For those of you new to investing, I know it can be exciting, challenging and sometimes a bit overwhelming. After all, investing doesn’t generally come naturally. It's not like riding a bike. The reality is that the language of investing is often obscure and the rules and regulations can be complicated.
That said, investing is the best way I know to build wealth. So I'm offering a three-part series to help you crack the code—starting with the most important foundational concepts. Then in the next two columns I'll define and describe the investments, accounts, and steps to take to put these concepts to use.
If you've been afraid to ask questions and start investing, I encourage you to read on. The challenge is worth the effort.
A few words about risk
Like everything in life, investing carries risk. The only way to have a chance at a gain is to take the chance of having a loss. Sometimes more risk means the potential for more gain—but not always. As an investor, your most important job is to understand how and when to take on smart risk—risk that's appropriate for your situation and that carries the potential for commensurate reward.
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Two cornerstone concepts for building a portfolio—asset allocation and diversification
Asset allocation and diversification may sound complicated, but the concepts behind them are quite simple. Plus, they are the most important building blocks for creating a portfolio.
1) Asset allocation: Building an investment portfolio is a bit like building a house; you need a master plan. In investing, this master plan is your asset allocation, or the way you divvy up your money between various asset classes, such as stocks, bonds, cash. Your asset allocation can range from aggressive to conservative and will help determine both your level of risk as well as your potential for gain. Here are some examples:
- An aggressive asset allocation is made up largely of stocks, which carry significant risk of loss and higher volatility but also the potential for significant growth. This would be appropriate for someone young and saving for retirement because they can keep their money invested for the long term and ride out market ups and downs.
- At the other end of the spectrum, a conservative allocation is made up largely of investments that have less risk of loss as well as lower potential for growth. Investments such as U.S. Treasury bonds, CDs, or other types of fixed income investments are more stable than stocks. These investments are most appropriate for an older person with a shorter time to keep their money invested or someone who has a short-term goal. These types of investments can also add ballast to a stock portfolio.
- A moderate portfolio falls somewhere in between.
As an investor, selecting and adhering to your chosen asset allocation is job number one. Before you decide to buy an investment, ask yourself, "Will stock XYZ or fund ABC fit into my asset allocation and provide enough potential growth to justify its risk?" If not, it's not the investment for you.
2) Diversification: In plain English, diversification means not putting all your eggs in one basket; in other words, spreading your risk among many different types of investments that aren’t likely to go up or down at the same time. In practice this means owning lots of stocks and/or bonds, each with different characteristics. Even if you want to invest aggressively, it's more prudent to have a portfolio that's globally diversified across a wide variety of industries and sectors of the economy rather than owning a small handful of companies.
Diversification isn't a magic bullet; it can't guarantee a profit or eliminate the risk of loss. However, if you don't diversify, you're setting yourself up for a huge hit if your chosen investment falters. (If any one investment equals more than 10 percent of your portfolio's value, that's known as a concentrated position—a red flag!)
As I'll discuss in the next column, purchasing mutual funds or exchange-traded funds is an efficient way to diversify, and can provide the foundation for your portfolio regardless of what kind of investor you are.
Why you shouldn't try to time the market
There's a saying, "time in the market is more important than timing the market." Before you invest a penny, repeat those words. Even the most experienced investors can't accurately predict how much and when the market will move in a particular direction.
So what's an investor to do? Get in and stay in. Missing out on even a few days of the market can be costly. Missing just the top 10 days of the market represented by the S&P 500 from 2001-2020 would have changed an investor's return from 7.5% to 3.4%. With an asset allocation that matches your risk tolerance and time horizon, you don’t need to constantly monitor and tinker with your portfolio.
Dollar-cost averaging: A prudent strategy especially for new investors
Sometimes getting started can be the hardest part of investing. The good news is you don't have to jump in with both feet. A strategy known as dollar-cost averaging can help you ease in over time.
Here's how it works: every month (or any regular interval), you invest a set amount of money—regardless of how the stock market is performing. When the market is down and prices are low, you can buy more shares for your money. When the market and prices are up, you'll buy fewer shares.
For example, let's say you invest $400 a month for a year. In the first month, you purchase 40 shares of Stock XYZ at $10 per share. If the price goes up to $12 in month two, you'll only purchase 33.33 shares. If the price falls to $8, you'll purchase 50 shares. The key is holding steady at $400 every month. Despite the inherent volatility of the stock market, it tends to go up over time.
Of course, no strategy, dollar-cost averaging included, can protect against losses when stock prices tumble. The best course of action is to create an appropriate plan and take action on that plan by getting invested—and staying invested.
Coming up next
In this column I've introduced concepts that will be the foundation of your success as an investor. In the next two weeks you'll learn ways to put these concepts to work. Stay tuned!
Have a personal finance question? Email us at email@example.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.