Investing is a great first step toward building wealth for yourself and your family. But because there are so many options for how to invest — and your choices are so tailored to your personal preferences — putting your money to work can be a little overwhelming.
Here’s a quick investing 101 to help get you started, starting with definitions.
- Stocks are a share in a company. These tend to be riskier investments, but also typically offer more potential for profit over time.
- Bonds are a share of debt issued by a business or the government. These are safer investments, typically returning a lower profit than stocks over time.
- Cash and cash equivalents are readily available cash and short-term investments like certificates of deposit (CDs). These are the safest investments, but typically return little profit over time.
These are the most common categories of investments — often referred to as asset classes. There are also alternatives like commodities or real estate that require some more advanced knowledge.
Now that we’ve defined the main types of investments, let’s talk about what you’ll want to know as you start building a portfolio (the collection of investments you own).
RISK TOLERANCE AND TIME HORIZON
These will impact how you invest.
Risk tolerance is basically your emotional ability to deal with losing money. If you invested $1,000 today, could you deal with it being worth $500 for a period of time? That’s possible if you invest heavily in stocks, which tend to increase in value over time but can be volatile from one day to the next. If you answered yes to being okay losing a great deal of money for a period of time, then you have a high risk tolerance.
Time horizon is the amount of time before you want to use your money. If you’re planning to use the money to make a down payment on a home within the next three years, you have a short time horizon and would likely have less risk tolerance. If you’re not planning to use the money until you retire in 30 years, then you have a long time horizon and can afford to take on more risk.
ASSET ALLOCATION AND DIVERSIFICATION
Asset allocation and diversification are about putting you in a position to grow your money in a smart way.
Asset allocation is the percentage of stocks, bonds or cash you own. If you have a high risk tolerance and long time horizon, you’re likely to want a larger percentage of stocks because you’ll be able to weather ups and downs and make more money over the long term. On the other hand, if you have a low risk tolerance and short time horizon, you probably want more cash and bonds so that you don’t lose money right before you need it.
Diversification splits your investments among different groupings or sectors in order to reduce risk. That includes your asset allocation. But it also includes where you invest within asset classes. For instance, you might diversify between stocks in companies located within the United States and stocks in companies located in Asia.
Different sectors of the economy do better at different times. It’s tough to predict which one will do well in any given year. So when you diversify and own stocks across different sectors, you are positioned to make money on whatever sector is performing well at the time.
If you’ve done a good job with asset allocation and diversifying, then the balance of your portfolio is likely going to get out of whack over time as one sector does better than another. For instance, let’s say you wanted 10 percent of your stocks to be companies in Asia. If companies in Asia have a great year, those companies may now make up 15 percent of your stocks. In that case you’ll want to sell some of those stocks and use that money to buy more stocks (or even bonds) in parts of your portfolio that didn’t do as well.
You might also decide to rebalance your portfolio if your risk tolerance or investment timeline has changed — perhaps as you get closer and closer to retirement.
Either way, it’s a good idea to rebalance your portfolio at least once a year and possibly more often. Once you’re ready, there are several ways to invest and different types of accounts that get different tax treatment.
Because there are so many options for how to invest — and your choices are so tailored to your personal preferences — putting your money to work can be a little overwhelming.
WHERE TO INVEST
You could invest directly through your retirement plan if you have one at work. Typically work-sponsored retirement plans have limited options that usually consist of funds — which are collections of stocks or bonds. Some funds are professionally managed. Others are designed to mimic a particular index like the S&P 500. Target-date funds are also popular. Those funds automatically rebalance to a less risky allocation as you approach the end of the target date (which is typically close to the year you want your money — maybe the year you’re planning to retire).
You could also invest directly through a broker. That could mean opening an online trading account that you manage yourself or working with a financial planner or professional.
TYPES OF ACCOUNTS
Tax-qualified accounts get favorable tax treatment. These include retirement accounts like 401(k)s, 403(b)s, IRAs and Roth accounts. Because these accounts get special treatment, there are typically limits on who can use them and how much someone can contribute.
Non-qualified accounts don’t get special tax treatment. This means you’re free to invest as much as you would like in them.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.