“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”  Robert Kiyosaki, Rich Dad Poor Dad

Investing, which involves putting your money to work, is a great first step toward building wealth for yourself and your family. If you think investing is gambling, you’re doing it wrong. The world of investing requires discipline, planning and patience. And, the gains you see over decades can be exciting. The three most common categories of investments, referred to as asset classes, include:

1. Stocks – which are a share in a company. These tend to be riskier investments, but also typically offer more potential for profit over time.
2. Bonds – which are a share of debt issued by a business or the government. These are safer investments, typically returning a lower profit than stocks over time.
3. Cash and cash equivalents – which are readily available cash and short-term investments like certificates of deposit (CDs). These are the safest investments, but typically return little profit over time.

 

Before you start investing, it is important for you to understand a few basic concepts and definitions, such as:

Risk Tolerance

Risk tolerance is basically your emotional ability to deal with losing money. If you invested $1,000 today, could you deal with it being worth $500 for a period of time? That’s possible if you invest heavily in stocks, which tend to increase in value over time but can be volatile from one day to the next. If you answered yes to being okay losing a great deal of money for a period of time, then you have a high risk tolerance.

Time Horizon

Time horizon is the amount of time before you want to use your money. If you’re planning to use the money to make a down payment on a home within the next three years, you have a short time horizon and would likely have less risk tolerance. If you’re not planning to use the money until you retire in 30 years, then you have a long time horizon and can afford to take on more risk.

Asset Allocation

Asset allocation is the percentage of stocks, bonds or cash you own. If you have a high risk tolerance and long time horizon, you’re likely to want a larger percentage of stocks because you’ll be able to weather ups and downs and make more money over the long term. On the other hand, if you have a low risk tolerance and short time horizon, you probably want more cash and bonds so that you don’t lose money right before you need it.

Stocks, bonds and cash tend to respond differently to market conditions (one may go up when the others go down). Asset allocation helps you spread your money so that when one asset class unexpectedly zigs, your whole portfolio doesn’t zig along with it. In this way, asset allocation can help ensure your portfolio is correctly positioned to help you reach your financial goals, no matter what is happening in the market.

Diversification

Diversification splits your investments among different groupings or sectors in order to reduce risk. That includes your asset allocation. But it also includes where you invest within asset classes. For instance, you might diversify between stocks in companies located within the United States and stocks in companies located in Asia.

Different sectors of the economy do better at different times. It’s tough to predict which one will do well in any given year. So when you diversify and own stocks across different sectors, you are positioned to make money on whatever sector is performing well at the time. A well-diversified portfolio can help lessen the impact of market ups and downs on your portfolio.

Rebalancing

If you’ve done a good job with asset allocation and diversifying, then the balance of your portfolio is likely going to get out of whack over time as one sector does better than another. For instance, let’s say you wanted 10 percent of your stocks to be companies in Asia. If companies in Asia have a great year, those companies may now make up 15 percent of your stocks. In that case you’ll want to sell some of those stocks and use that money to buy more stocks (or even bonds) in parts of your portfolio that didn’t do as well.

Rebalancing on a regular basis (once or twice a year, for example) can help ensure your portfolio remains aligned with your goals. And because it provides a disciplined approach to investing, portfolio rebalancing also may prevent you from buying or selling investments based on emotion.

Dollar Cost Averaging 

Dollar cost averaging (DCA) involves putting your investment plan on autopilot.  With DCA, you invest a set amount at set intervals (for example, $200 every month) in the market. By investing systematically, you’ll buy more shares of an investment when the market is lower, fewer when the market is higher, and some when the market is in between. Over time, this may help you to pay a lower average price for the total shares you purchase.

DCA takes the emotion out of investing, helping you to start on your investment plan sooner, rather than later. And once you begin, DCA can also help you remain focused on your goals, no matter what’s happening in the market. It helps make investing a habit.

Capital Gains

Capital gains is an increase in the value of an asset or investment over time. Capital gains is measured by the difference between the current value, or market value, of an asset or investment and its purchase price, or the value of the asset or investment at the time it was acquired {cost basis}.

Realized capital gains and losses occur when an asset is sold, which triggers a taxable event. Unrealized gains and losses, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment’s value but are not considered a capital gain that should be treated as a taxable event.

Capital gains are classified as either short-term or long-term. Short-term capital gains, defined as gains realized in securities held for one year or less, are taxed as ordinary income based on the individual’s tax filing status and adjusted gross income. Long-term capital gains, defined as gains realized in securities held for more than one year, are usually taxed at a lower rate than regular income.

“If you want to become really wealthy, you must have your money work for you. The amount you get paid for your personal effort is relatively small compared with the amount you can earn by having your money make money.” John D. Rockefeller

Before you start investing or putting your money to work for your, do your homework and research. Once you’ve made a decision, make sure to re-evaluate the assets in your portfolio on a regular basis. A good asset today may not necessarily be a good asset in the future.

And, don’t panic during the inevitable setbacks and don’t be fearful during the inevitable stock market corrections that all long-term investors face. If the reasoning behind the investment decision was sound when purchased, stick with the assets, and they should eventually recover and grow.

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References:

1. https://www.investopedia.com/financial-edge/0511/the-top-17-investing-quotes-of-all-time.aspx
2. https://www.northwesternmutual.com/life-and-money/how-to-invest-a-beginners-guide/
3. https://www.northwesternmutual.com/life-and-money/4-investment-terms-you-should-know/
4. https://www.investopedia.com/terms/c/capitalgain.asp