I’m so glad you’re back and ready to learn more! To recap, last month we talked about one of the easiest ways to start investing; Employee Sponsored Retirement plans. My hope is, by now you’ve turned on contributions to your employer’s 401(k), 403(b) or whatever you have available to you. The most important thing is that you STARTED.
Now let’s take a deeper dive into the fundamentals of investing.
Why Do We Invest?
We invest for the intention of putting our money to work, so it can grow. When you put your money to work for you, the less work you must do to save. This is the concept of compounding; when we invest, and then reinvest earnings, our money grows at a much faster rate.
Say you have a $100,000 savings goal that you want to accomplish in 10 years. You have the option to save it at your bank and earn 2.0% annually in interest (assume interest rates don’t increase or decrease over the next 10 years) or invest it over the next 10 years and earn an average 8% return per year.
If you choose to save the money at your bank, you would have to contribute $91,242.73 to your account to reach $100,000 in 10 years. If you invest the money instead, you would only need to contribute $67,962.50. That’s $23,280 less you’d physically have to save in order to reach your goal if you invest versus put your money in bank savings account.
We also invest to outpace inflation.
Our current inflation rate is hovering right around the 2% mark. Simply put, inflation is the reference to how the average price of a product or service increases over a given time period. This impacts the buying power of our money. $1,000 back in 2008 is not the same as $1,000 today. The same item that cost you $1,000 back in 2008 would cost you $1,166.30 if purchased today due to inflation.
Because we typically save for the long-term, and over time our money loses buying power, investing is one of the most common ways to outpace inflation. This helps our money hold its value in the future.
Understanding Asset Classes helps us make sound investment decisions.
Asset classes represent a group of instruments that have similar characteristics and will react similarly to market conditions. The three biggest asset classes in investing are Equities/Stocks, Fixed Income/Bonds, and cash/cash equivalents. Each asset class will have a different risk associated with it; with higher risk comes higher potential for returns.
Asset classes are important when it comes to diversifying our investments. Since asset classes tend to react similarly to market conditions, we want to spread out our risk by investing in different asset classes. This helps us to avoid putting all our eggs in one basket. If you’re 100% invested in US-Equities and the US enters a recession, your portfolio is going to take a huge hit.
Risk Tolerance is a key factor in determining how you feel about investing your money.
Risk tolerance is what helps us to decide how we should invest our money. Risk tolerance describes our level of comfort when the markets fluctuate. Someone who gets anxious and looses sleep at night over a decrease in their portfolio value is risk averse. Someone who sees a market drop as a buying opportunity or has no real emotional reaction to sell is risk tolerant. Understand though, that the trade-off for risk is returns. Someone who takes less risk should understand that they are accepting lower returns. Where a risk-tolerant investor will take on more risk in exchange for higher returns.
Typically risk tolerance decreases with age. As we get older, and our investment time horizons shorten, meaning we have less time to recover from market fluctuations. Therefore, we are less willing to take on higher levels of risk.
If you’re risk tolerant, you’re more likely to have heavier allocations to equities in your portfolio. Whereas, someone who is risk averse will include more fixed income within their portfolio to decrease their risk potential.
Your Time Horizon is the amount of time you plan to invest your money.
Understand that we need to choose investment vehicles based on time horizon. A longer time horizon might mean we are willing to take on more risk because we know we have the time to recover from losses in the market.
On the other hand, shorter investment time horizons will align with lower-risk investment vehicles. Which means trading off for a lower return because they don’t have the time to recover from losses.
At the end of the day, remember asset allocation, time horizon, and risk tolerance are just a handful of factors when picking the appropriate investments. Educate yourself and continue to learn about the fundamentals of investing. And, as always, feel free to reach out with any questions, concerns, etc. I’m here to be part of your team.
Carolyn Rowland is a CERTIFIED FINANCIAL PLANNER™ passionate about empowering individuals to take control of their financial landscape. “We often tend to place our own priorities on the back burner for others, resulting in sacrifices we don’t often realize we’re making.”Carolyn believes in taking a values-based approach to financial planning. “Together we’ll define what matters most to you, what you want your life to look like, and develop a plan that fits your lifestyle.”CC
Carolyn Rowland is in the Milwaukee WI, area.