To keep ahead of inflation.
Inflation has reduced the purchasing power of your dollars over time. According to the U.S. Department of Labor, the average annual inflation rate since 1914 has been around 3%. If $100 is $100 today, it would cost $181 in 20 years. Inflation has skyrocketed, but most experts agree it will settle back down. Investing in stocks is your best hedge against inflation.
To take advantage of compound interest.
Anyone with a savings account understands the basics of compounding: the funds in your savings account earn interest, and that interest is added to your account balance; the next time interest is calculated, it’s based on the increased value of your account. In effect, you earn interest on your interest.
Many people, however, don’t fully appreciate the impact compounded earnings can have, especially over a long period. To benefit from the longest possible investment period, the sooner you start investing, the more time your investments have for potential growth. Waiting too long can make it very difficult to catch up.
Consider the examples. Let’s say you invest $5,000 a year for 30 years. After 30 years, you will have invested a total of $150,000. Yet, assuming your funds grow at precisely 6% each year because of compounding, you will have over $395,000 after 30 years. This is a hypothetical example and is not intended to reflect the actual performance of any specific investment. Taxes and investment fees, and expenses are not reflected. If they were, the results would have been lower.
Investing is Risky Business
Investing is different for every individual. The investment plan that’s right for you depends mainly on the level of comfort you have when it comes to risk. You can’t completely avoid risk when it comes to investing, but it’s possible for you to manage it.
Investors are typically grouped into three categories for purposes of discussing risk tolerance:
- Aggressive: those who have a high degree of risk tolerance
- Moderate: those willing to accept a modest amount of risk
- Conservative: those who have low risk tolerance
When it comes to investing, there’s a direct relationship between risk and potential return. This is true for investment portfolios as well as for individual investments. More risk means a greater potential return but also a greater chance of loss. Conversely, less risk means lower potential returns and less likelihood of loss. This is known as the risk/return tradeoff. You can’t have it all. There’s a relationship between growth, income, and the stability of our investments, and when we move closer to one, we generally move away from another. This is a dilemma all investors face.
Only you can know your risk tolerance level when it comes to investing. Let’s now look at the types of investments and their level of risk and return.
Cash alternatives are low-risk, short-term, and relatively liquid instruments that you may use.
- To provide you with relative stability
- To maintain a ready source of cash for emergencies or other purposes
- To serve as a temporary parking place for assets until you decide where to put your money longer term
Examples of cash alternatives include:
- Certificates of deposit (CDs)
- Money market deposit accounts
- Money market mutual funds
- U.S. Treasury bills (T-bills)
Now let’s talk about the next instrument: bonds.
Bonds are essentially loans to a government or corporation, which is why they’re called “debt instruments.” Bonds are issued in denominations as low as $1,000. The interest rate (or coupon rate), which can be fixed or floating, is set in advance, and interest payments are generally paid semiannually. Bond maturity dates range from 1 to 30 years. However, bonds don’t need to be held until they mature. Once issued, they can be traded like any other type of security. Currently, bonds are at historic lows, so many experts are suggesting people replace the bonds in their portfolios with alternatives. You can listen to episode 56 of the Her Retirement Podcast, What’s Better Than Bonds, to further understand what’s happening with bonds and what are some alternatives.
- U.S. government securities
- Agency bonds
- Municipal bonds
- Corporate bonds
Now I’m going to go over Stocks.
When you buy company stock, you’re actually purchasing a share of ownership in that business. Investors who purchase stock are known as the company’s stockholders or shareholders. Your percentage of ownership in a company also represents your share of the risks taken and profits generated by the company. If the company does well, your share of the total earnings will be proportionate to how much of the company’s stock you own.
The flip side, of course, is that your share of any loss will be similarly proportionate to your percentage of ownership. If you purchase stock, you can make money in two ways. First, corporate earnings may be distributed as dividends, usually paid quarterly. Second, you can sell your shares. If the value of the company’s stock has increased since you purchased it, you will make a profit. Of course, if the value of the stock has declined, you’ll lose money.
Types of stock
- Stock is commonly categorized by the market value of the company that issues the stock. For example, large-cap stocks describe shares issued by the largest corporations. Other general categories include midcap, small-cap, and microcap.
- Growth stocks are usually characterized by corporate earnings that are increasing faster than their industry average or the overall market.
- Value stocks are typically characterized by selling at a low multiple of a company’s sales, earnings, or book value.
- Income stocks generally offer higher dividend yields than market averages and typically fall into the utility and financial sectors and other well-established industries.
Common vs. preferred stock
Common stockholders hold many rights, including the right to vote. However, common stockholders are last in line to claim the earnings and assets of the company. They receive dividends at the board of directors’ discretion and only after all other claims on profits have been satisfied.
Preferred stockholders are given priority over holders of common stock when it comes to dividends and assets. Preferred stockholders do not receive all of the privileges of ownership given to common stockholders, including the right to vote. Preferred stockholders typically receive a fixed dividend payment, usually quarterly. For preferred stockholders, there is less return potential than for common stockholders; there is less risk.
Let’s talk about Mutual Funds.
The principle behind a mutual fund is quite simple. Your money is pooled, along with the money of other investors, into a fund, which then invests in certain securities according to a stated investment strategy. The fund is managed by a fund manager who reports to a board of directors. By investing in the fund, you own a piece of the total portfolio of its securities, which could be anywhere from a few dozen to hundreds of stocks. This provides you with both a convenient way to obtain professional money management and instant diversification that would be more difficult and expensive to achieve on your own.
Another concept I want to explain is active vs. passive management
An actively managed fund is one in which the fund manager uses their knowledge and research to actively buy and sell securities in an attempt to beat a benchmark. A passively managed account called an index fund typically buys and holds most or all securities represented in a specific index (for example, the S&P 500 index).
The objective of an index fund is to try to obtain roughly the same rate of return as the index it mimics. Funds are commonly named and classified according to their investment style or objective:
- Money market mutual funds invest solely in cash or cash alternatives.
- Bond funds invest solely in bonds.
- Stock funds invest exclusively in stocks. Stock mutual funds can also be classified based on the size of the companies in which the fund invests–for example, large-cap, mid-cap, and small-cap.
- Balanced funds invest in both bonds and stocks.
- International funds seek investment opportunities outside the U.S. Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Get a copy and review it carefully before investing.
Now let’s cover Dollar Cost Averaging.
Many mutual fund investors use an investment strategy called dollar-cost averaging. With dollar-cost averaging, rather than investing a single lump sum, you invest small amounts of money at regular intervals, no matter how the market is performing. Your goal is to purchase more shares when the price is low and fewer shares when the price is high. Although dollar-cost averaging can’t guarantee you a profit or avoid a loss, a regular fixed dollar investment may result in a lower average cost per share than if you had bought a fixed number of shares each time, assuming you continue to invest through all types of markets.
For example, let’s say you decide to invest $300 each month toward your child’s college education. Because you invest the same amount each month, you automatically buy more shares when prices are low and fewer shares when prices are high. You find that your average cost per share is less than the average market price per share over the time you invested.
On to another concept called Asset Allocation.
It’s almost universally accepted that any portfolio should include a mix of investments. That is, a portfolio should contain investments with varying levels of risk to help minimize exposure. Asset allocation is one of the first steps in creating a diversified investment portfolio.
Asset allocation is the concept of deciding how your investment dollars should be allocated among broad investment classes, such as stocks, bonds, and cash alternatives. The underlying principle is that different classes of investments have shown different rates of return and levels of price volatility over time. Also, since other asset classes often respond differently to the same news, your stocks may go down while your bonds go up, or vice versa. Diversifying your investments over non-correlated or low-correlated asset classes can help you lower the overall volatility of your portfolio. However, diversification does not ensure a profit or guarantee against the possibility of loss.
How do you choose the mix that’s right for you? Many resources are available to assist in asset allocation, including interactive tools and sample allocation models. Most of these take into account several variables:
- Objective variables (e.g., your age, the financial resources available to you, your time frames, your need for liquidity)
- Subjective variables (e.g., your tolerance for risk, your outlook on the economy)
Ultimately, though, you’ll want to choose a mix of investments that has the potential to provide the return you want at the level of risk you feel comfortable with. For that reason, it makes sense to work with a financial professional to gauge your risk tolerance, then tailor a portfolio to your risk profile and financial situation.
Factors that should be considered:
- Risk tolerance
- Investment time frames
- Personal financial situation
- Liquidity needs
Asset Allocation–Sample Models
Everyone’s situation is unique. Nevertheless, in general, conservative asset allocation models will invest heavily in bonds and cash alternatives, with the primary goal of preserving principal.
This asset allocation suggestion should be used as a guide only and is not intended as financial advice. It should not be relied upon. Past performance is not a guarantee of future results.
In comparison, a moderate asset allocation model will attempt to balance income and growth by allocating significant investment dollars to both stocks and bonds. This asset allocation suggestion should be used as a guide only and is not intended as financial advice; it should not be relied upon. Past performance is not a guarantee of future results.
An aggressive asset allocation model will concentrate heavily on stocks and potential growth. This asset allocation suggestion should be used as a guide only and is not intended as financial advice. Past performance is not a guarantee of future results.
How a Financial Professional Can Help
As you’ve seen, there’s a lot to consider when investing. A financial professional or retirement advisor can help you:
- Determine your investment goals, timelines, and risk tolerance
- Evaluate markets and investments
- Create an asset allocation model
- Select specific investments
- Manage and monitor your portfolio
- Modify your portfolio when necessary
I hope you’ve found some value in this Investment Basics overview. There’s so much more to investing, but this will give you the basics you should know. I encourage you to listen to Episode 56: “What’s Better Than Bonds?” for an overview of the issue with bonds in a pre-retirees and retirees portfolio. Also, listen to Episode 10: “Retirement Portfolio Design for a Changing Economy.” While Her Retirement does not provide investment advice, we seek to help women understand investing topics so that more information conversation can happen and more informed decisions can be made. It’s all about knowing more and having more. Let’s Get Her Done. Thanks for listening.