Investing 101: Essential Investing Concepts
No matter how much experience you have with investments, there's always more to learn. The more investing 101 knowledge you have as you grow your nest egg and plan for retirement, the better. And as you increase your investing knowledge, a financial advisor can be a great resource. They'll explain the nuts and bolts of investing and any opportunities you should take advantage of. A financial advisor can also give you valuable feedback on your investing plans and show you how to reach your retirement goals.
Before your first meeting, think of a few topics you'd like to learn more about. To get started, brush up on these investing 101 concepts.
Setting Goals
Before selecting specific investments, it's worthwhile to think about your investment goals and the time frame in which you hope to reach them. Maybe you'd like to build up investments that could provide income when you retire in 25 years, or perhaps you're aiming to cover the down payment on a new house in 10 years. With your goals in mind, a financial advisor can help you determine which investment vehicles are right for you and how much you'll need to invest each month to stay on schedule.
Risk
One of the most important investing 101 concepts is the trade-off between risk and reward. Each investment comes with its own level of risk - there's a chance that you'll lose money if its value drops. And each investment has the potential to earn a return and grow your savings. Investments that offer higher returns often involve more risk, while less risky investments typically don't generate high returns. For example, cash is often thought of as a less risky asset, but keeping money in cash won't usually result in high returns.
Retirement Planning
A financial advisor can help you set up a retirement account such as an IRA or Roth IRA and create a plan for growing your assets. They can also help you evaluate sources of income like Social Security that will be available to you and determine when a realistic retirement date might be. Usually, the goal is to set aside a small portion of your income each year until you reach retirement age. Saving a small amount each month can add up to a comfortable nest egg for retirement because you have the ability to gradually earn compound returns over time.
Compounding
You may find that the monthly amount you need to invest is lower than you expect, especially if your goal is still several years away - this is all because of the power of compound returns. Compounding means that when you earn a rate of return, the rate applies both to the money you invested and to previous returns. For example, suppose you invested $1,000 and earn a return of 5 percent per year.
After one year you have: $1,000 + $50 = $1,050
But the next year, you have: $1,050 + $52.50 = $1,102.50
Although the return stayed the same, the amount earned on top of your principal went up.
Those gains can snowball the longer you hold on to an investment, which you can see by doing some calculations. The Rule of 72 is a tool that shows approximately how long it will take an investment to double in value. It says that 72 divided by the annual rate of return is about the number of years it takes for the investment to double. For example, at a 6 percent rate of return, it takes about 12 years for an investment to be worth twice as much. Try out a few different rates with a compound interest calculator to help visualize how fast your money grows when it earns compound returns.
Diversification
The expression, "don't put all of your eggs in one basket" applies to investing too. To make sure that your investment portfolio can safely weather a downturn or other changes in the economy, financial advisors usually recommend that you diversify your investments. That means investing in many companies from a diverse range of industries and geographical regions. Then if any particular investment holding drops in price, the effect on your portfolio is small because no individual investment makes up a large share of your holdings. It's often easy to diversify by investing in funds that bring together a lot of different securities.
Asset Allocation
Just as you want to invest in a diverse range of companies when you buy stock, you also want to divide your portfolio among different types of assets like stocks, bonds, cash, and real estate. The exact mix of assets, or asset allocation, that's right for you depends on your goals and your tolerance for risk.
Evaluating Performance
Because there's a close relationship between risk and returns, checking up on your investment portfolio's performance requires looking at both how much the value of your assets changed and also how much risk is involved. A financial advisor can help you evaluate how your portfolio is performing relative to risk. Once you understand the fundamentals of investing, you can apply your knowledge to your own investing and retirement planning.