Understanding basic principles is critical to making smart investment decisions. Although it may seem complicated to the masses, smart investing is not rocket science. In fact, the most important and obvious investment principle is good old common sense. It’s important to understand what you’re investing in, so if you work with a financial advisor or broker, feel free to ask questions and be specific. The better you understand the information about your investments, the more comfortable you will be with the course you’ve chosen.
Buying stock in a company is purchasing fractional ownership in that business by becoming a shareholder. Stock is synonymous with equity, when you become a shareholder you own a stake in the company’s future earnings and profits. If the company prospers, there’s no limit to how much the stock price can increase in value. Conversely if a company fails, you could lose up to the total dollar amount you invested. As a shareholder you are not the boss, nor are you responsible for covering losses in the event of a bankruptcy.
When you buy bonds you’re lending money to the company, or sometimes a government or municipality. Bonds are synonymous with debt, instead of an owner, you become a creditor of the bond issuer. Think of a bond like an IOU. By lending money to the company your risk losing up to the full amount that you lent, which was your investment. In return the company will offer a stated “coupon rate”, which is effectively the amount of interest they are willing to pay to borrow from you. If the bond issuer fails, that is referred to as a default. As a creditor you priority over stock holders. That means if there were a bankruptcy or liquidation of the company you could potentially recover some or all of your investment prior to equity owners receiving anything at all.
Pie charts and investing go hand in hand, seriously. Asset allocation the key to long term investment success, and often times the pie charts you see have something to do with asset allocation. Effectively, asset allocation is determining what percentage of an entire portfolio should be invested in which asset classes. At a very basic level Stocks, Bonds and Cash are the primary asset classes. According to modern portfolio theory, 90% of a portfolios long term return is a result of asset allocation, so yes this is really important.
Certain asset classes react different to one another and may increase or decrease in value at different times. Ideally, with a diversified asset allocation strategy, in times when some of your investments are decreasing in value, others will be increasing. It’s never a perfect science, but ultimately the gainers should help to offset the losers, helping to minimize the impact of losses from a single investment over time. It’s important to find the right balance of different asset classes for your investment portfolio that aligns with your goals, risk tolerance and time horizon.
While having the right mix of stocks, bonds and cash is important, it’s more than just that. Everyone has heard the expression “don’t put all your eggs in one basket” but unfortunately many people still do. Consider diversifying your portfolio further by selecting several different investments in similar asset classes. For example, Large-Cap stock is a specific asset class comprised of the largest companies in the world. By investing in companies across different sectors such as technology, healthcare, manufacturing, etc. you can diversify your risk amongst Large-Cap stocks. It’s possible that manufacturing could perform poorly while technology is doing quite well, this is just one of many examples as to why diversification is also very important. Diversification can’t guarantee profits or ensure against the possibility of loss, but it can help you manage how much risk you take in your portfolio.
Recognizing the relationship between risk and return is key for managing your expectations about investing. Every choice we make about our money involves some level of risk, even putting it in the bank. Risk is the possibility that you might lose money, or that your investments will produce lower returns than expected. The investment return is your potential reward for making the investment. Return can be measured by an increase or decrease in the value of your original investment. Risk is a bit harder to measure, but there are many different methods to do so. In general, if you are seeking a higher return then you must also be willing to assume a higher level of risk. If you are seeking lower risk, then you must be willing to accept a lower potential return. If you hear someone talking about “guaranteed investment returns” or “no risk investing” you should definitely be skeptical and probably run the other way. If it sounds too good to be true, it probably isn’t true.