Investing Risks — What You Need To Know
You do not want to put your money out into the investing world without knowing the risks. Investing is not an automatic get rich quick scheme. However, if you are aware of the ground rules, it is a great opportunity to build wealth over time.
The first ground rule that you need to know about is your asset allocation. If you are not comfortable with the concept, you can still invest. But you should limit your investments only to vehicles that manage your asset allocation for you, e.g., a target date fund.
Finance Like an Adult
Simple solutions are the best option to solve complex problems. Investing is an incredibly complex opportunity that can become problematic for the unprepared. However, simple tricks on Microsoft excel or google sheets can strengthen your understanding of the ground rules of investing.
The most daunting risk associated with investing is losing your hard-earned money. The first ground rule of investing involves diversifying your investment vehicles to shield you from this risk.
If you want to start with a high-level summary, please skip to the end and read the 50 Word Takeaway before continuing.
Ground Rule #1 of Investing
The first ground rule of investing is determining the proper asset allocation for your investment portfolio. Your asset allocation is the percent of your investment placed in investment vehicles with varying levels of risk (e.g., stocks vs. bonds).
Understanding your desired asset allocation is the first ground rule of investing because a diversified portfolio is the most efficient method to avoid investment losses over time. Investment vehicles do not follow the same trend over time, stocks/bonds/cash all perform differently under unique circumstances.
Therefore, diversify your portfolio so it does not rely on a single stock or bond, or just investments in stocks or bonds. This will protect you from the inevitable dips each investment vehicle suffers while it is active.
What Should Your Asset Allocation Be?
Your asset allocation is a percentage (0% to 100%) of the amount you invested in high-risk vehicles (e.g., stocks) and low-risk vehicles (e.g., bonds or cash). These two percentages should combine to equal 100%.
The rule of thumb with asset allocation is to subtract your age from 100, for example a 25 year-old results in 75. The result is the percentage you should invest in higher risk investments. However, this rule of thumb is just a starting point, not an exact answer.
Your ratio of high-risk to low-risk investments depends on two factors:
- Your personal comfort with the risks and rewards of investing, and
- When you are planning on using the money you invested.
The rule of thumb detailed above is a great place to start when estimating your asset allocation.
The next step is to reflect on your comfort with investing. The key question to ask yourself is, are you comfortable staying invested in the market when it drops? The worst thing your can do as an investor is buy high and sell low.
The purpose of a diverse asset allocation is to allow you to wait out any temporary dips in the market. If you are not comfortable waiting and know you will trade poorly performing investments, then you must lower the percentage asset allocation in high-risk investments. If you are comfortable, you can consider raising the percentage allocated to high-risk investments.
Remember: this first step assumes that you believe the underlying investment will recover and gain value over time. There is no shame to take a loss on an investment vehicle that appears to be on a permanent decline.
The second step to consider is how long you will be invested. There are different allocations for retirement savings that cannot be accessed for over 20 years or savings that could help you buy a car in the next 5 years.
The closer the intended purpose of the investment, the more conservative your asset allocation should be. More time allows you more flexibility to deal with the volatile nature of higher-risk investments.
To summarize: subtract your age from 100 to estimate the allocation to high-risk investments. Then consider if you have the stomach to deal with investment losses (assume no if you are not sure). If not, lower your allocation in high-risk investments from your initial estimate. Finally consider the timeline for the purpose of your investments. If you need the money within 5 years, lower the allocation in high-risk investments even further. If you do not need the money in the next 20 years raise the allocation in high-risk investments.
What Should You Do Next?
The next step is to invest! Use your desired asset allocation to guide you in the ratio that you invest in high or low risk investment vehicles. Remember to periodically monitor your asset allocation throughout time.
As your investments change in value (hopefully growing substantially), your asset allocation will change with them. What is most likely to occur is your high-risk investments will increase in value quicker than your low-risk investments. If this is the case you will need to rebalance your asset allocation by investing more in lower risk investments.
If this all sounds too complicated or frustrating to manage, then focus on investing in investment vehicles that manage your asset allocation for you. The most common examples are target date funds.
Target date funds assume a date in which you will begin withdrawing your investment (e.g., a 2060 target date fund assumes you will begin withdrawing money in the year 2060). The fund will rebalance its asset allocation to a more conservative amount as it gets closer to the target date, for a fee.
These fees will lower your returns from this fund. Only you can decide if this cost is worth avoiding the stress and frustration of rebalancing the asset allocation of your investment portfolio.
Takeaway: In 50 Words or Less
The first ground rule of investing is diversify your investments to shield you from risk. Your asset allocation is the percent of your investment placed in investments with different levels of risk. Use your desired asset allocation to guide the ratio that you invest in high or low risk investments.
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