Learn Investment Part I
Author: John Smith
Building a Solid Foundation
Investing successfully is more about attitude than about money. Even an imminent inheritance and a good-paying job offer little hope of financial success without a positive, constructive attitude that leads to a rational, systematic investing approach. The solution to avoiding a stressful retirement and enjoying financial freedom starts by examining your attitudes. With a thorough self-assessment under your belt, you can begin learning sound investment fundamentals.
Profit by Understanding the Risk and Return Relationship
What is something you do really well -- better than most people? Whatever it is, your special skill or knowledge is probably characterized by two critical attributes:
It's rewarding. Whether the reward is financial or simply the satisfaction of doing something worthwhile, you profit by it in some way.
Developing your special skill or knowledge required some type of sacrifice.
Investment reward is called return. Return is the financial benefit of risking your money in the market. It is expressed as "rate of return." Investment sacrifice is called risk. The essence of investment risk is the chance you take that the value of your investment will decline. Investment risk is usually expressed in terms of volatility in the value of the investment. The value of some investments, such as government bonds, does not change much, so the chance of losing money is slight. On the other hand, the value of stocks issued by many Internet companies rapidly rises and falls and may not recover. After analyzing your personality and grasping the concepts behind risk and return, you are ready to tackle the one simple fact that underlies the importance of investment risk and return: they are both positively and linearly related.
In order to earn higher returns, you have to assume higher risk. If you are unwilling to accept high risk, your returns will be relatively low. In the long term, all investment securities and portfolios operate this way. The key to successful investing lies in a plan that is not only well thought-out and consistently applied, but one that accounts for and manages risk as well. A risk management plan expresses your personal tolerance for risk in terms of the kinds of investments you should own.
Assessing Your Risk Tolerance
Your risk tolerance is about personal preferences and goals. The cornerstone of a consistently applied risk management plan lies in an assessment of your own tolerance for risk and volatility. This leads to an investment plan reflecting both your personality and tolerance. A thorough risk tolerance assessment taps two key attributes: cash flow needs and your attitude about short-term fluctuation in the value of your investments. Cash flow is money coming in and then going out for expenses. If you depend on investment income to fund your cash flow, your investments should include safe stocks and bonds paying high dividends and interest. If you depend on employment income to fund your cash flow, you can invest in riskier, low-income stocks and bonds with greater potential to grow in value over the long-term.
Your financial obligations and preferences determine cash flow needs. If you are approaching retirement, you may not currently have large cash flow needs. But upon retirement, your income source may shift from salary to earnings on your investments. It is at this moment when knowing yourself becomes extremely important, since you will be able to anticipate your reaction to seeing the value of your portfolio take occasional dives and experience long periods of no growth. By anticipating your reaction, you'll be prepared either to adjust your investment strategies or to sit back and ride out the storm.
Matching Reward Expectations with Risk Tolerance
If stock prices rise, it means the market believes profits will rise at roughly the same rate. In the long run, the economy cannot grow fast enough to sustain high double-digit profits. Therefore, stock prices could not sustain the high double-digit returns we witnessed in some recent years.
A reasonable long-term return expectation hovers between 8 and 10 percent if the investor's risk tolerance permits allocating 60 to 80 percent of the portfolio to stocks and the remainder to fixed income investments. Investors with lower risk tolerance should expect less of a return.
It can take both discipline and foresight to put money in low-risk investments. Nevertheless, a mismatch between realistic expectations and risk tolerance is a sure formula for disappointment. A well-conceived risk management plan matching risk tolerance and realistic expectations can prevent disaster while yielding respectable long-term returns.
Getting a Good Start With Sound Strategy
The Big Picture: How Investments Dovetail With Assets
A balance sheet is a cumulative record of finances recorded at a single point in time. It is a three-part compilation of everything you own, everything you owe and everything you have left over. The difference between what you own and what you owe -- known as assets and liabilities, respectively -- is your balance sheet equity, also known as net worth.
A balance sheet provides a bird's-eye view of finances in a way that lets you see how all of the pieces make up the whole and whether any adjustments need to be made. Balance sheet equity offers an objective measure of financial freedom. Each addition to assets, without an offsetting addition to liabilities, directly increases net worth. And here lies the ultimate goal of investing: increasing your net worth.
The first step toward financial freedom demands sufficient liquid assets to fund short-term liabilities and foreseeable obligations, such as home repair or a car replacement fund. Your balance sheet should include categories devoted to specific future obligations. Once these categories have been funded, you can then devote your attention to increasing your net worth through investments.
Asset Allocation
Asset allocation is a process of continually dividing your assets into categories to maximize returns and control the risk of lost principal. As we move through this course, you'll see how the concept behind asset allocation can also be applied to investments. Effective asset allocation includes liquid asset categories to fund contingencies such as unexpected car repairs. You should also have funds devoted to foreseeable obligations such as insurance co-pays and deductibles. However, you may not want to allocate all the funds up front for long-term obligations. It's a better idea to pay for these in smaller installments.
Your personal judgment is also central to how these funds are actually invested. Liquid investments can be converted to cash at any time without losing any of the money you initially invested. Contingency funds should be in cash or highly liquid investments, such as money in a savings account. If you put contingency funds in stocks, an illiquid form of investment, there's no telling what the fund will be worth if you eventually decide that you need the cash to pay your bills. Likewise, funds devoted to short-term foreseeable obligations should be liquid, though with these funds you have a little more latitude in your decision-making process. If you know beforehand when you will need the money, you can invest in higher-earning certificates of deposit or short-term bonds whose maturities match the timing of your obligations.
Diversification: Capitalizing on Diversity
The markets offer many kinds of investments that differ in their risk and return characteristics. Before thinking about your many choices, it is important to have a clear idea of the advantages of diversification. By sampling many different types of investments and including a proper mix in your portfolio, you ensure stability and a well-rounded portfolio.
Diversification allocates investment assets into categories that respond differently to economic events. This helps preserve your portfolio's value, mainly because some investments rise while others fall. Investors also practice diversification to capitalize on unforeseeable growth and increase their net worth. For example, only a few investors anticipated in 1998 that oil service stocks would triple over the next two years. But, if you had a balanced and diversified portfolio that included many different types of investments, there's a good chance that you too might have capitalized on the growth of oil service stocks.
Diversification not only provides protection, but it also offers an opportunity for profit.
Fixed Income vs. Equity Investments
All investments can be categorized as either fixed income or equity. When discussing investments, equity is not quite the same as balance sheet equity. Equity, as it relates to investments, is something you own, such as stock or rental property. Fixed income is a loan you make to somebody who promises to repay principal and interest. Bonds, the most common form of fixed income investment, promise a specified amount of interest and specified maturity date when the loan is to be repaid.
Fixed income and equity respond somewhat differently to economic events. Changes in the interest rate directly influence the value of fixed income investments. While rising interest rates reduce their value, falling interest rates will increase their value. Although interest rate increases do tend to suppress stock values, equities are far more sensitive to anticipated future corporate earnings than anything else. This distinction is important because stock prices change even when interest rates are stable, and the value of fixed income can change even when corporate profits are stable.
Within the two general investment categories of fixed income and equity, there are many possibilities for diversification, all of which possess different properties. For example, bonds with long maturities (e.g., 10 to 20 years) are more sensitive to interest rate changes than shorter-term bonds. You may want to select several different types of investment to protect yourself from any unforeseeable benefits or problems. Among equities, stocks issued by utility companies, for example, are less sensitive to economic changes than stocks issued by retail companies.
An Overview of Asset Categories
Successful diversification depends on your knowledge of your own asset categories and how each category responds to economic events. A useful approach conceptualizes investments along two dimensions: equity and fixed income investments, and international and domestic investments.
Your personal preferences and goals drive asset allocation and diversification. If your overall financial plan requires income from your investments, your portfolio should have only a few investments that risk principal and more with fixed income investments. If your plan seeks portfolio growth and you have a long time horizon, use fewer fixed income investments and more equities and international investments.