Risk is a part of investing. The key is to be smart about that risk.
Asset allocation and diversification are two of the most important keys to your success as an investor.
If you're just getting started, think about dollar-cost averaging, or easing in over time.
If you're new to the world of investing, welcome. In this first column of a three-part series, I want to help you crack the code—starting with the most important foundational concepts. And then in the next two columns I'll define and describe the investments, accounts, and steps that will allow you to put these concepts to use over time.
Investing isn't something that comes 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 that I know to build your financial future. So if you've been afraid to ask questions and get started, I encourage you to read on. The challenge is worth the effort.
Let's start with a few words about risk
Like everything in life, investing carries risk. There's no way around it. The only way that you have a chance to make a gain is to take the chance that you might have a loss. Sometimes more risk means the potential for more gain—but not always. As an investor, your most important job is to understand the difference: when the risk you're taking is giving you the opportunity for greater return—and when it isn't. In other words, you only want to take on smart risk—risk that's appropriate for your situation and that carries potential for reward.
Building a portfolio: Two cornerstone concepts
Building an investment portfolio is a bit like building a house; you need to start with a blueprint. In investing, this blueprint is your asset allocation, or the way you divvy up your money between various asset classes, such as stocks, bonds, cash, and other investments.
Your asset allocation will help determine both your level of risk as well as your potential for gain. An aggressive asset allocation would be comprised largely of stocks, carrying significant volatility as well as the potential for significant growth. An aggressive portfolio would be appropriate for someone who is young and saving for retirement because he or she has the time to ride out the downs.
At the other end of the spectrum, a conservative allocation means investments such as U.S. Treasury bonds, Certificates of Deposit (CDs), or other fixed income, and is most appropriate for an older person or someone who wants to avoid risk. This type of portfolio probably won't lose value, but it won't gain much, either. A moderate portfolio falls somewhere in between.
As an investor, selecting and adhering to your chosen asset allocation is job number one. Before you even think about buying an investment, you have to think about what you need in terms of growth potential and risk control. Before you decide to buy, ask yourself, "Will stock XYZ or fund ABC fit into my asset allocation?" If not, it's not the investment for you.
The second most important concept in investing is diversification. In plain English this means not putting all of your eggs in one basket or, in other words, spreading your risk among many investments. If one ship sinks, you won't lose the entire fleet.
In practice this means that you need to own several stocks or several bonds, each with different characteristics. Even if you're convinced that you want an aggressive portfolio, you need to own a minimum of 10-15 stocks, and preferably more. 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 roughly 20 percent or more of your portfolio's value, that's known as a concentrated position; a definite no-no!) As I'll discuss in the next column, purchasing one or several mutual funds or exchange-traded funds is an efficient way to diversify, and can provide the foundation for your portfolio.
Don'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. Many of the best performing days immediately follow market dips.
So what's an investor to do? Get in and stay in. You need to carefully select and monitor your holdings, making adjustments as needed—but to be successful, you have to stay in for the long term. Otherwise you greatly increase your chances of getting in (or out) at precisely the wrong time.
Dollar-cost averaging: A prudent strategy
Sometimes getting started can be the hardest part of investing. The good news is that you don't have to jump in with both feet. A strategy known as dollar-cost averaging can help you ease in over time.
This is how it works: every month (or at 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.
As an example, let's say you decide to invest $400 a month for a year. In the first month, you may 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. And if the price falls to $8, you'll purchase 50 shares. The key is holding steady at $400 every month.
Of course, no strategy, dollar-cost averaging included, can protect you against losses when stock prices tumble. And if the market were to go straight up, you'd be better off purchasing all of your shares as soon as possible. But dollar-cost averaging can be a prudent way to ease into the markets, finding your footing as a new investor. (You should be aware that this strategy involves a continuous investment in securities regardless of fluctuating price levels. Think about your financial ability to continue your purchases through periods of low price levels.)
In this column I've introduced you to concepts that will be the foundation to your success as an investor. In the next two weeks you'll learn more about ways to put these concepts to use. Stay tuned!
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