Basics of Investing: Investment Road map

Investment Roadmap and Guide to Meeting Your Financial Goals

The entire concept of investing is often scary for beginners, causing many people to stick with their 401(k)s and other employer-sponsored retirement plans.

If you choose the right assets and select a level of risk that you are comfortable with, investing should give you peace of mind.

Investing is one of the most effective solutions for helping people reach their financial goals, but it requires planning.

Here is what you should know before investing your money…

The Most Common Types of Investments

The first step in investing is understanding your options. You can invest in hundreds of different tangible and intangible items, including stocks and even rare coins.

Investors divide these investments into asset classes. The three main classes include stocks, bonds, and cash.

Stocks or equities allow you to purchase shares of ownership in one or more publicly held companies. When the companies perform well, the value of the stock increases. Stocks tend to offer higher potential returns over long periods of time, but also bring greater risk and volatility.

Bonds are a type of fixed-income investment. When you buy a bond, you lend money to the issuer. You may purchase government, corporate, or municipal bonds.

The issuer promises to pay you back the principal while also paying interest on the principal. When the bond matures, you receive any outstanding principal and interest. Bonds offer less volatility compared to stocks, but with lower potential returns.

Cash investments include physical cash, savings accounts, money market accounts, commodities, and certificates of deposit (CDs).

With cash investments, you often experience limited risk and reward. These are the safest investment options, providing a foundation for many portfolios.

CDs are one of the most secure options. You purchase these certificates from banks. The CD has a fixed period. When the period expires, you receive the initial investment plus interest.

CDs may include fixed or variable interest. With variable interest, the rates may change based on the Fed’s interest rate. Issues related to the economy or inflation may limit the interest you earn.

With fixed interest, the rate remains the same throughout the life of the CD. However, besides fixed versus variable interest, you may also need to choose compound versus simple interest.

What Is Compound Interest?

Compounding is a term used to describe how compound interest works. It also provides a method for projecting the growth of a portfolio.

Some investments provide returns based on interest. This includes savings accounts, money market accounts, CDs, and most bonds. With these assets, you earn simple interest or compound interest.

With simple interest, the issuer calculates interest based on the initial principal. For example, if you invest $5,000 in a CD with 5% simple interest earned annually, you would earn $250 each year until the CD matures.

With compound interest, the interest earns interest. After investing $5,000 in a CD with 5% compound interest calculated annually, you would still earn $250 at the end of the first year. However, the $250 would earn interest in the second year.

Instead of earning 5% on $5,000 during the second year, you would earn 5% of $5,250. The compound interest provides greater returns, especially with long-term investments.

Compounding formulas also help investors predict the growth of their portfolios. For example, if you anticipate 10% growth over the next 10 years on a $10,000 investment, compounding would help you determine the expected growth. Over 10 years, your $10,000 investment would reach about $25,940.

Pay Attention to the Frequency of Compounding

The frequency of compounding also impacts your earning potential. With a faster rate of accrual, you experience faster growth.

For example, if you earn 5% compound interest quarterly, you would earn more compared to 5% compound interest calculated annually.

Basically, compounding helps increase the growth rate of your investment. Whenever possible, choose compound interest over simple interest.

Which investments offer compound interest? The most common example is a bank account. Savings accounts, CDs, and money market accounts all typically earn compound interest.

Some bonds also offer compound interest. With most bonds, you receive fixed interest sums, allowing for predictable growth forecasts. However, zero-coupon pounds include compounded growth.

Lump-Sum Investing Versus Dollar-Cost Averaging

Lump-sum investing is an alternative to investing money over time with dollar-cost averaging (DCA). DCA and lump-sum investing are the two primary options for deciding how much and when to invest.

Trying to time the market to find the best entry point often results in missed opportunities. However, investing all your money at once also brings risks. Immediately after a major investment, the market may crash.

Dollar-Cost Averaging

To offset the risks, some investors choose to use the dollar-cost averaging method. With DCA, you invest a specific amount of money at regular intervals, no matter the performance of the market.

For example, you may choose to invest $100 in specific security each week for an entire year. At the end of the year, you will have invested $5,200.

DCA allows you to invest without needing to worry about the volatility of the market over a short-term period. As you cannot predict minor fluctuations in the market, DCA tends to provide a more secure investment solution.

The drawback to DCA is that you may limit your earning potential. By holding off on investing all your money at once, your smaller investments may not earn as much if the market performs well at the start of the year.

Lump-Sum Investing

As with DCA, lump-sum investing allows you to invest without worrying about the short-term volatility of the market. You simply invest a lump sum all at once, instead of doling it out over time.

The concept behind lump-sum investing is that the markets tend to tick upward over time. According to several studies, the markets often experience three positive years for every one negative year.

By investing more money upfront, you may gain more during a long-term investment strategy.

For example, if you invest $5,200 in January and you average a 5% gain for the year, you would earn $260 on that investment. However, if you used DCA, you may not earn as much, especially if the market waited until the end of the year to experience an upswing.

Active Versus Passive Investing

The next consideration is whether you want to actively or passively invest your money. With active investing, you select individual stocks or bonds. You are actively analyzing and hoping to select investments with the best returns based on market conditions. With mutual funds, an investment manager actively selects stocks or bonds.

Passive investing includes investments that do not require active research or analysis. This includes optional investments where you try to match the performance of the market instead of trying to beat the market.

Exchange-traded funds (ETFs) are a type of passive investing. You do not need to learn more about individual stocks.

If you want to take the time to research stocks, bonds, the state of the economy, and market conditions, you may enjoy active investing.

With active investing, you become more involved in the selection of investments. However, if you do not have the time to explore options, passive investing still provides a suitable option for achieving your financial goals.

How Much Should You Invest?

The amount that you invest depends on many factors. If you just came into a large inheritance, you may want to invest a lump sum. However, if you have a limited income, you may not have a lot of money to work with.

Many financial advisors recommend investing at least 10% of your income. If you already contribute 5% of your income to a 401(k), contribute another 5% to your own investments.

Timing is equally important. Waiting too long limits your earning potential.

Investment Road Map for a Secure Future

Using the basics discussed above, you can start planning your investment strategy. Use the following investment roadmap to build a portfolio that matches your financial needs:

  • Define your goals
  • Establish a budget
  • Pay off your debts
  • Rate your risk tolerance
  • Explore investments
  • Diversify your portfolio

Rushing the process may not result in financial losses. However, you may limit the amount that you earn or tie up your money in investments that you cannot easily liquidate. Take the time to review each of these steps.

Define Your Financial Goals

Before you invest, decide what you hope to achieve. Do you want to save for retirement or save for your child’s college education?

Deciding on these goals helps you set a timeframe, which also allows you to choose the amount of risk you can tolerate.

Establish a Budget and Pay Off Debt

When you first start investing, consider starting with the most stable investment – your savings account. You need to save money to have money to invest and a savings account provides a minimal return with no risk.

Saving money also requires a budget and less debt. Determine how much income you bring in and how much you have left over after bills and expenses are paid. If you have any remaining debts, ensure that you include repayments in your budget.

Taking longer to pay off your debts results in more interest over the life of the debt. This may eliminate any gains that you get from your investments.

Begin Gauging Your Risk Tolerance

One of the first steps in investing is analyzing your risk tolerance. This is the variability in value that you can stomach without withdrawing your investment early.

High-risk assets may experience sudden swings, dropping in value before stabilizing. Dealing with a volatile market is necessary when investing in assets with higher risk.

Explore Your Investment Options

Reviewing your investment options requires you to consider the current economy and your financial goals. One of the biggest factors is the time frame for reaching your goals.

You may plan on achieving financial goals within the next year or decade. This time frame directly influences the level of risk you should take on.

For short-term goals, you may want to choose investments with less risk, providing guaranteed gains over a specific period.

Common investment options include:

  • Stocks (growth stocks, income stocks, value stocks, blue-chip stocks, stock mutual funds)
  • Bonds (corporate bonds, high-yield bonds, municipal bonds, US treasuries)
  • Cash (savings accounts, money market accounts, certificates of deposit)

When choosing investments, remember to analyze your risk tolerance and time horizon. Start with the most stable investments to begin building your portfolio and then expand your investments to include assets with varying levels of risk and reward.

Diversify Your Portfolio

Experienced investors and portfolio managers often recommend diversification. Allocating your assets across a variety of investment vehicles provides more balance.

If you have stable, low-risk investments, you may find it easier to deal with the volatile high-risk markets.

Many investors use a ratio to determine their asset allocation, with set percentages for each of the three main asset classes. For example, you may allocate 60% of your total investments in stocks, 30% in bonds, and 10% in cash.

While diversification is a recommended practice, you do not need to worry about asset allocation until you begin to grow your portfolio.

Always start small. Choose one or two stable investments before adding to your portfolio. As the number of investments grows, you can begin making decisions based on the asset allocation ratio that you set.

Conclusion – Plan Before You Start Investing

The bottom line is that smart investing requires planning. If you want to maximize your potential return on investment, you need to manage the risks.

You cannot expect to achieve superior returns compared to a savings account without assuming the risk. However, you should also avoid taking on more risk than you can handle.

To strike the right balance between risk and reward, set your financial goals. Decide how much you need to earn and how much time you have available.

Remember to choose investments with compound interest over simple interest whenever possible. Investing a lump sum also provides a superior option compared to dollar-cost averaging.

Along with these tips, ensure that you diversify your portfolio as you begin to add investments.

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