Investing For Your Future Monthly Message
Barbara O’Neill, Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Investing Risks, Diversification, and Action Steps
Happy New Year and best wishes for success in 2015 as a saver and investor. Even though the words "saving" and "investing" are often used interchangeably (e.g., “I’m saving for retirement”), there are differences between the two. Saving provides funds for emergencies and purchases in the relatively near future (less than 3 to 5 years away). Safety of the principal and liquidity (ease of converting funds to cash) are important features of savings dollars. Because of these characteristics, savings dollars generally yield a low rate of return and often do not maintain purchasing power.
Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk (of loss of principal), however, and should be considered only after you have adequate savings. Investments also offer the potential for a higher rate of return than cash equivalent savings products (e.g., money market funds and CDs)
Generally speaking, risk and rate-of-return are directly related. As the risk level of an investment increases, the potential return usually increases as well. This is often illustrated with a pyramid illustration indicating the risk and return associated with various types of investments. As investors move up the pyramid from, say, money market funds to stocks, they incur a greater risk of loss of principal along with the potential for higher returns. Total return is the profit (or loss) on an investment. It is a combination of current income (cash received from interest, dividends, etc.) and capital gains or losses (the change in value of the investment between the time you bought and sold it).
All investments have one or more types of risk. Diversifying an investment portfolio by selecting a variety of securities is a frequently used strategy to reduce potential losses. Done properly, diversification can reduce about 70% of the total risk associated with investing. If you put all your money in one place, your return will depend solely on the performance of that one investment. Alternatively, if you invest in several different types of assets, your return will be a weighted average of your various investment returns. Below are three basic ways to diversify your investments:
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