For some of us who are new to investing, the financial world can seem like a distant planet using a foreign language, loaded with technical concepts and complicated terminology. Yet, while it may seem overwhelming to listen to a heap of investment jargon that you don’t quite understand, it’s important to get the general basics under your belt and start breaking down the gist of it. Now, more than ever, it’s easy to get started. You don’t need a degree in economics or a ton of money to be able to get into investing efficiently. Starting small and gaining an understanding of the general concepts, risk management and market techniques is a great step in the right direction of financial growth.
Whether you are just starting out or already in it feeling like you are driving blind, these 4 important practices will, undoubtedly, help you better understand your investments.
UNDERSTANDING YOUR RISK
No matter what kind of investment you choose to make, you will always run into some degree of risk. You will come to find out most investments that you make won’t have a guaranteed rate of return. So, understanding exactly what risk entails and gauging your own personal appetite for risk should be the first task of any potential investor.
In the world of investing, it’s important to realize that risk can come in several different ways. The most visible form would be concentration risk, which essentially means putting all your eggs in one basket. This is when your portfolio isn’t diversified and relies heavily on one or just a few investments. Another form would be overlapping risk which means buying similar or same sector investments that can be heavily affected by the same external event. This can blindside an investor who may think that they have a diversified portfolio. Another risk that any potential investor must take into consideration is not taking enough risk. This can mean that a person is too conservative or safe. While you may have heard the phrase “no risk it, no biscuit” being thrown around in the sports bar, it can also relate to the risk/reward paradigm of the investment world. It’s important to not invest in too many investments that are deemed “safe” to avoid the possibility of interest rate or inflation risk. It’s possible that your investments can be so conservative that you’re actually not letting your money work for you to its most potential and, therefore, could actually be losing ground to inflation. Ultimately, risk is a natural part of investing and you need to find your comfort level and build your personal portfolios accordingly.
Now that you have a better understanding of the risk involved in investing, let’s dive into how you can help mitigate it. The most crucial way to increase your investment returns and reduce your overall risk is the act of diversifying your assets. The main idea here is that you don’t want to put all your eggs in one basket. If you put all your money into just one investment and it ends up performing badly, you can then lose all your money. Alternatively, if you create a diversified portfolio that involves a variety of different investments, it’s much less likely that all of your investments will perform badly.
One of the most important ways to diversify your portfolio is to invest in several different asset classes. The three main asset classes that should round out your portfolio include stocks, bonds and cash.
• Stocks (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation’s assets and profits equal to how much stock they own. While stocks can offer the highest potential gains, they also carry the most inherent risk. They are the heavy hitters, if you will. Expect to hit some home runs but also, deal with some strikeouts.
• Bonds are units of corporate debt issued by companies and securitized as tradable assets. A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common. Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa. These fixed-income securities have maturity dates at which point the principal amount must be paid back in full or risk default.
• Cash, or the money you have in your savings account, involves the least amount of risk with, alternatively, the least potential return.
UNDERSTANDING HOW TO BUILD YOUR PORTFOLIO
So, now you know the different asset classes and their levels of risk but how do you figure out how much to invest in each asset class? This process of divvying up your investment portfolio is referred to as asset allocation which is, ultimately, dependent on your risk tolerance, personal goals and time horizon. Asset allocation can be crucial to your portfolio because, traditionally, asset classes tend to not move together in tandem. Stocks will tend to perform better in a rising economy, whereas bonds will tend to increase their returns when interest rates are falling. Gauging the market conditions along with assessing your risk tolerance is crucial when making up your portfolio. If you have a high risk tolerance and a longer time frame to invest, you may elect to have an aggressive portfolio which features a higher allocation of stocks compared to bonds. Alternatively, if you have a low risk tolerance with a shorter time horizon, your portfolio may be more conservative with more bonds compared to stocks.
UNDERSTANDING MARKET EMOTIONS
You put your money in the stock market and, inevitably, just punched your ticket to an imminent roller coaster of emotions. So, buckle up because the ups and downs are just a normal part of the investment journey. It’s important to understand that controlling your emotions during these market swings is crucial to the long-term health of your investments. When you buy a stock and it starts performing well, you are, undoubtedly, going to experience an excitement and thrill and want to see how much money you can make. Then if your stock starts declining, you may feel a rush of negative emotions like anxiety, depression and fear while wanting to sell before you lose more money. It’s all a part of the game and one must acknowledge the cycle and trust the process. It’s important to understand that time is your greatest asset when it comes to investing, specifically in stocks. Let’s say that you just have one year to invest before you need to use the funds. In this case, you may be put into a risky situation where you could lose all of your money. This could cause heightened emotions while you are watching the market closely and could take a toll on your mental health. Alternatively, if you have an extended period of time to work with and a long-term plan the day to day changes in the market will just be noise in the bigger picture of your investments.
Ultimately, psychological factors can have huge implications on, not only a personal scale, but on a larger collective scale in the market. Making rational decisions and not allowing emotions to dictate your investment decisions will greatly strengthen the long-term results of your portfolio.