5 Investing Concepts Everyone Should Know
Investing is actually really easy. Don’t let anyone tell you otherwise (and read our story on how to invest to see what we mean). But it’s also true that when you’re trying to learn about investing, it can seem complicated and tortuous.
A lot of the mystery has to do with how people talk about investing — investing is an entire industry unto itself, a whole 'nother world, really, with a language of its own. Knowing some of the key words and phrases can help you be a better investor.
Here are five investing concepts you should know:
1. Time horizon
Your time horizon is one of the most crucial aspects of being a successful investor. And by “successful,” we mean building wealth over time by investing in a diversified portfolio.
Luckily, all it takes to know your time horizon is to answer a simple question: How much time do you have until you want to use this money? Answering that question tells you the best place to invest your money. (We talk a lot about this in the context of your overall goals in our story on how to invest.)
For example, if you want to invest money that’s intended to fund your retirement, then you might have decades for it to sit and grow — emphasis on grow — so why not let the stock market work its magic on your money? You have time to ride out the market’s volatility in exchange for its higher average returns. Sure, your portfolio’s value may drop at times, but your long-term time horizon means you’ve got time to wait it out.
But… time does keep passing, doesn’t it? Not much we can do about that. And that’s an important aspect of an investor’s time horizon: It keeps changing. It’s crucial that you check in on your investment portfolio regularly — once a year makes sense for most of us — and re-ask that all-important question: How much time until I need this money?
Check in on your investment portfolio regularly and re-ask that all-important question: How much time until I need this money?
If your goal, e.g., a down payment to buy a home, is getting into the range of five years or less, then it’s time to shift out of highly volatile investments into more staid ones, like a high-yield savings account or short-term bonds, so that when it comes time to withdraw your money for your goal, it’s sitting there waiting for you.
2. Risk tolerance
Getting a handle on your tolerance for risk is a way to make sure you build an investment portfolio that works for you for the long haul.
Basically, your risk tolerance helps you understand how much risk you’re OK with in your portfolio, so you can rest assured that when market volatility happens — and it will happen — you’ll be prepared for it and will refrain from making rash decisions. Or really, one rash decision: selling all of your holdings in an investment when their value is at its lowest.
Your risk tolerance is closely tied to your time horizon (see above). If you’re investing in a way that matches your time horizon — for example, stocks for longer-term goals, less volatile investments for shorter-term goals — that can help you navigate volatility even if it makes you nervous.
- Create an investment plan. This could be as simple as a sentence on a piece of paper or a note on your phone that says something to the effect of: “My investing plan for my long-term goal of retirement is to invest 70% of my portfolio in stocks and 30% in bonds, and to hold this allocation until I’m 10 years out from retirement.”
- On those days when you pop in to check your brokerage account or your 401(k) balance and you see that your account has lost a bunch of its value: Revisit that plan. Read it. Breathe deep. Stay calm. Log off from your account. Go outside.
Along with your time horizon, asset allocation is also closely tied to risk tolerance. Asset allocation — how you divide up your money into different types of investments — can help reduce your portfolio’s volatility. Read more about what asset allocation is and why it matters.
3. Passive vs. active
No, we’re not talking about couch potatoes vs. all you triathlon types. In investing, passive vs. active refers to your approach to buying and selling investments.
- Passive investors tend to seek long-term gains with a fairly hands-off investing approach and a low time commitment. Passive investors might build a do-it-yourself portfolio of index mutual funds or ETFs, or they might let the pros guide them by investing in a target-date fund or by using a robo-advisor.
Either way, after picking their investments (or letting the pros pick ‘em), they then sit back and hold for the long-term, without much, or any, buying and selling, other than perhaps contributing additional money to their portfolio. Check out our story on how to invest for retirement for specific passive investing ideas.
- Active investors like to pick individual stocks and other investments. They usually time their trades based on their research into market conditions, specific investment sectors and types, and other factors. Some active investors are day traders, buying and selling an investment over the course of a day, while others may hold investments for years before selling. For more info, check out our free trading guide on sister site StockTrader.com.
You can be active or passive; you can even be both, if you like — for example, by investing passively for the bulk of your portfolio (e.g., for retirement) and being an active trader with some small chunk of play money.
4. Dollar-cost averaging
Dollar-cost averaging refers to the idea of investing a regular amount of money on a regular basis throughout the year, no matter what the financial markets are doing and no matter what price you’re paying for those investments. If you’re contributing to a 401(k) or other workplace retirement plan through your paycheck, you are dollar-cost averaging. Congratulations! It’s a great way to build wealth over time.
The main benefit with dollar-cost averaging is you’re not trying to time the market — that is, gauging the best time to buy (note: market timing is really hard and time-consuming and impossible to get right all of the time). Instead, you’re buying no matter what’s happening in the market, which means you’re buying shares when they’re cheap as well as when they’re more expensive.
The beauty of dollar-cost averaging is all of these things:
- You don’t have to have a big lump sum to keep investing. You can invest $50 a month, or even $10.
- You can put your investing on autopilot — a great way to build your wealth relatively painlessly — by having paycheck deductions going to your workplace plan or by setting up automatic transfers between your bank account and your IRA. (Don’t have an IRA? Why the heck not? Read all about the pros and cons of IRAs).
- You can stop worrying about when is the best time to invest. You are simply investing all of the time.
- During market crashes, dollar cost averaging ensures you are investing right when the market turns around and heads up. Talk about market timing! Sweet!
One big caveat, of course, is that with dollar-cost averaging, you are investing even when the market is heading down and your investments are dropping in value. But for the long-term, buy-and-hold investor (that is, you’re investing for a long-term goal like retirement), that is OK.
The assumption is that the market will eventually rise again. Just ask the buy-and-hold investors who stayed in the market throughout the 2008-09 market crash: They made back their losses and gained even more thanks to the 10+-year bull market that followed that crash.
In investing, diversification is all about reducing risk. A diversified investment portfolio is one that includes many different types of investments so that even if one group of investments starts to lose value, the other groups are less likely to be falling in tandem. This helps reduce your portfolio’s volatility over time.
At a very high level, diversification means including both stocks and bonds in your portfolio. But diversification can get as granular as grains of sand on a beach. You can opt to invest in large-cap, mid-cap and small-cap stocks, U.S. stocks and international stocks, stocks from emerging and developed markets, tech stocks and blue chip stocks, companies that produce consumer staples and companies that produce consumer discretionary products. The list goes on.
And there’s a list for the bond portion of your asset allocation too: U.S. Treasurys vs. municipal bonds vs. high-yield corporate bonds vs. investment-grade corporate bonds. Et cetera.
Don’t forget commodities. And real estate! For some investors, gold and/or cryptocurrency are another path to diversification. In fact, there are so many investment types to choose from, it can get overwhelming, not to mention confusing.
It doesn’t have to be. Go to our story on how to invest for retirement to learn about two ultra-simple ways to create a diversified investment portfolio.
What Is Asset Allocation?
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