If you are young and upwardly mobile, you may have a carefree attitude toward investing. The newest iPad is a more practical use of your resources, you reason. Think again! Generation X has no time to slack off. With fewer assets than your parents on average, investment advisors say you must start saving today to prepare for retirement.
The idea that you can invest money in high-return investments to make up for lost time is a dangerous fallacy. Longer term, low risk investment strategies deliver a higher return. So, what is the right level of risk to provide safety and meet retirement goals? Welcome to the first and most important step of investing – determining your risk profile.
The universe of investment securities keeps growing and can seem daunting to a beginner investor. How do you decide what to invest in – stocks, bonds, mutual funds, ETFs – how much and for how long? Once you know your risk profile, allocating the right mix of investment securities to your investment portfolio becomes easy.
- Investing 101: Why invest now?
Most investors share the same goal – to earn as high of returns as possible on our investment portfolios while minimizing the risk of losses. Yet with higher market volatility becoming the norm, it is tempting to leave your money in a savings account.
While interest rates are slowly inching up from historical lows since the 2008 financial crisis, a return of 1-3 percent will not be enough to beat inflation. The prices of goods and services will continue to slowly rise between now and your retirement days, reducing the purchasing power of each dollar you earn.
An inflation rate calculator can provide an idea of how quickly the value of your money can erode. The first generation iPad you bought for $500 in 2010 would cost you $546 in 2015. To maintain your consumption patterns in your golden years, you need to make a return that is higher than the inflation rate. Since 2000, the average inflation rate has been about 3 percent, close to the 100-year average.
Test your knowledge! Try our Investing 101: What’s Your Investment IQ?
- Investing 101: What is your risk profile?
You will need more oomph in your investment portfolio to beat inflation, but too much growth means buying riskier investments. Determining your risk profile is the first step in developing your personal financial plan. Hundreds of free investment risk assessment tools are available online such as the Vanguard Investor Questionnaire.
Your age, lifestyle, budget – savings goals and income requirements – should all be considered. Other considerations are:
Time horizon – Estimate the amount of time you have to meet your financial goals. Do you plan to retire when you are 60, or 70? Will you live to 90, or 100?
Risk appetite – Your risk tolerance looks at how much of a decline in your investments you would be comfortable with – 5%? 20%? You may be young and have a good salary and thus meet the risk profile of an investor who can invest in high growth stocks.
If you are under high stress, though, due to the added risk, then it is not a good investment for you on an emotional level. Moreover, investors who are under stress are more likely to make bad investment decisions.
Financial situation – Review your expenses and income, and assets and liabilities. Your personal balance sheet will help determine how much you can allocate to investments each month.
- Investing 101: When do you need the money?
The younger you are, the more major expenses you will have between now and retirement. These expenses might include:
– A wedding (in two years)
– A house down payment (in three years)
– Children’s college tuition (20 years)
As a general rule of thumb, if you need these investments in the next five years, place them in a savings account, certificate of deposit or money market fund. The latter two investment vehicles have the best chance of keeping up with inflation.
On the other hand, if you need them within the next year, you will have to pay a fee to withdraw your money. For nearer-term expenses, place your money in a savings account.
- Investing 101: Where to Invest
Women hold investment assets with lower yields than men, yet when SigFig reviewed one million portfolios in 2014, the online investment platform found that women had a 12 percent higher return. How could that be?
Another wealth advisor, Betterment, came to the same conclusion as SigFig: men turn over their investment allocations more often than women. Women hold onto stocks longer and are less likely to sell when they underperform the market.
If you trade in and out of stocks, you are likely to have a lower investment return, like that of the active alpha male traders.
Equities
Pooled investment funds allow you to park your money in a diversified portfolio, which is more likely to deliver above market performance longer term.
Index Funds – track the major indexes such as the S&P 500. They are considered a passive, low risk investment.
Mutual Funds – are managed investment funds that pool the assets of investors. The four major types are fixed income, money market, stock and hybrid funds.
Exchange Traded Funds (ETFs) – are funds that trade on stock exchanges like stocks and sell shares to the public. Many are structured like diversified, low risk index funds. Like stocks, they can easily be bought and sold throughout the day.
Target Date Fund – is a type of mutual fund whose asset allocation gradually becomes more conservative as the date of retirement approaches.
Debt
Debt instruments are generally considered to be less volatile than equity and lower risk, but high risk debt instruments are also available, such as high yield debt, which pays high returns in exchange for high risk.
Fixed income securities provide steady income and tax advantages, and balance higher volatility in equity investment. They may provide steady income through interest payments.
Government bonds – According to the jurisdiction, income from municipal bonds and treasury bonds may be tax free at the federal, state or local level; and provide tax advantages when held inside a retirement vehicle.
Corporate bonds – typically pay higher interest rates than government bonds. A corporate bond index fund provides diversification and lower risk by tracking an index of corporate bonds.
See a more complete list of investment securities at Investopedia.
- Investing 101: How much should you allocate to stocks and bonds?
The old general rule of thumb was to subtract your age from 100 to determine your stock allocation, but today we are living much longer. Retirement advisors now subtract age from 110, or even 120. If you are 30, for example, your allocation would be 70 percent stocks and 30 percent bonds.
Hopefully, we have nudged you into starting to save for retirement, or rethinking your investment strategy.
Find out more on How Mutual Fund Investing Works
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