IFYF Monthly Investing Messages

Personal Finance January 02, 2015|Print

 

 


 

Investing For Your Future Monthly Message

January 2015

Barbara O’Neill, Extension Specialist in Financial Resource Management

Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

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:

  • Choose securities from a variety of asset classes, e.g., a mix of stock, bonds, cash equivalent assets, and real estate.

  • Choose a variety of securities or funds within one asset class, e.g., stocks from large, medium, small, and international companies in different industries.

  • Choose a variety of maturity dates for fixed-income (bond) investments.

    By diversifying, you won’t lose as much as you would by investing in just one security right before its market value goes down. However, if the market goes straight up from the time you start investing, you won’t make as much in a diversified portfolio, either. Historically, however, most people are more concerned about protection from dramatic losses.

    Time is an important factor for investors. Young investors with a long time horizon may choose investments that exhibit wide price swings (e.g., stocks) because time is available for fluctuations to average out. Families investing for a specific mid-life goal (e.g., a child’s education) may choose a more moderate course (e.g., balanced mutual fund) with opportunity for growth, but also more safety for principal. Individuals in or near retirement or those with a need to depend on investment income to cover daily expenses may select investments (e.g., bonds) that provide a guaranteed income stream.

    Want to start investing or ramp up your current investment activity?  Begin by developing a personal investment plan. Check each action step, below, as it is completed.

  • Determine the rate of return for your current financial holdings.

  • Establish short-, intermediate-, and long-term financial goals and estimate the length of time between now and when you want to achieve each goal.

  • Determine your investment preferences and identify your characteristics and needs as an investor.

  • Set aside time each week to learn about investing from newspapers, magazines, television, and/or web sites.

  • Assess your interest, skill, and time to make decisions about your investment portfolio. Proceed on your own or seek assistance from a certified financial planner or other qualified advisor.

 

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