When it comes to investing your money, you don’t need to be the Wolf of Wall Street or sign up for a trading course. However, you should know the basics, as well as a few of the finer points — and why your investing strategy might differ from a friend’s.
In this post, you will learn about different types of investments, how to put together a balanced mix of those investments, and why it’s important to keep that balance in check.
The Building Blocks of Investments
To start, here’s a breakdown of the different forms your investments can take.
Stock: A share of the value of a company which can be bought, sold, or traded as an investment.
Bond: An official document in which a government or company promises to pay back an amount of money that it has borrowed and to pay interest for the borrowed money.
Cash: Cold, hard money that is easily accessible.
Alternative investment: An investment in asset classes other than stocks, bonds and cash.
Diversification Explained
You’ve probably heard the phrase, “Don’t put all of your eggs in one basket”. A good long-term investment strategy requires that you diversify by having a combination of the above-mentioned types of assets in your portfolio.
Diversification is important because including different kinds of assets can reduce volatility (the ups and downs) and risk in your portfolio. This doesn’t mean that you will never have a negative year in your portfolio, but it can reduce the chances that your whole portfolio will take a nosedive if one investment tanks.
Diversifying Your Stock Allocation
Stocks can be classified in several different ways, and it’s important to understand the differences. They are often classified according to the size of the company you’re buying shares in, ormarket capitalization. Market capitalization is defined as the total value of the issued shares of a publicly traded company. The most common categories are large-cap, mid-cap and small-cap.
In your portfolio, you want to include some of each, with the bulk in large-cap, but some in mid-cap and small-cap as well. The exact definition of what makes a large-cap or small-cap stock can differ depending on the source, but here is a guideline:
- Large-cap: Total value of issued shares is over $10 billion
- Mid-cap: $2 billion–$10 billion
- Small-cap: $250 million–$2 billion
What is a mutual fund?
A mutual fund is an investment that can contain stock, bonds, cash, and alternative investments in a pooled investment — and you can buy a slice of the diversified pie. Mutual funds are often the go-to investment within 401(k) plans.
Mutual funds can be as specific as foreign securities in India, or as broad as an allocation fund that is 75% stock and 25% bonds. When you are evaluating which mutual funds to include in your portfolio, make sure you are putting together a core mix that includes those boring old stocks and bonds, and you can spice it up with mutual funds that specialize in foreign securities, real estate, or commodities (like gold or silver).
Do NOT just pick the mutual funds that had the highest return last year. Instead, base your decision on the underlying securities, or what is actually in the mutual fund. Check out this article on how chasing returns can affect your investment performance.
What is an ETF?
An ETF, or exchange traded fund, is a basket of investments that can include stocks, bonds, cash, foreign investments, commodities, or other types of investments.
The most significant difference between mutual funds and ETFs is that ETFs trade on the stock exchanges, while mutual funds are valued at the end of the trading day.
Growth Vs. Value
No, it’s not a boxing match. Stocks, as well as ETFs and mutual funds, can be classified by whether their underlying stock is “growth” or “value.” A growth company is one that is expected to grow rapidly, while a value company is one that is expected to continue to pay a dividend and will grow slowly and steadily.
Additionally, there are investments that are classified as blend, which means that the investments represent a mixture of growth and value. Many indexes, such as the Russell 1000, are considered blend.
Asset Allocation
Now that you understand the different types of investments and the importance of diversification, it’s time to determine your asset allocation. Asset allocation refers to the mix of investments that you have in your portfolio. To figure out an asset allocation that works for you, ask yourself the following questions.
1. What is the goal of the account that you are investing in?
If you are saving for a retirement that’s 30 years away, you should have a higher percentage of stocks in that account than an account that is earmarked for your child’s college expenses, which is only five years away. This is because although stocks usually have greater return over time, they have greater volatility.
2. Are you a risk-taker? Do you work in a steady, reliable job, or do you tend to take chances, like starting your own company?
If you cringe at the thought of taking risk, then you may want to invest on the low side of a stock to bond range. If you are still 20 or more years away from retirement, you still need to have the majority of your portfolio in stocks, unless you plan on saving 30% of your income when you could normally be saving only 15%.
3. How much of my portfolio should be in stocks?
A financial planner can help you determine this. One rule of thumb is to take 110 and subtract your age, and the difference is the amount of stock that should be in your portfolio.
Using this method, if you’re 35, you would have somewhere around 75% in stock, and the rest (25%) in bonds. If you wanted to add in something like real estate, you could have 65% in stock, 25% in bonds and 10% in real estate. Try this easy calculatorto get started.
How does company stock factor in?
You may work for a company that matches your contributions to your retirement plan in company stock, or you may have a Employee Stock Purchase plan, where you can purchase stock at a discount.
If you’re in either situation, just make sure that you don’t have too much of your total portfolio in your company’s stock. A good rule of thumb is to have no more than 10-20% of your total investments in any one stock.
If this isn’t possible, then just make sure you are not also investing part of your 401(k) into company stock. Check out this great article for more information on what you can learn from employees at doomed companies like Enron.
If you spend a little bit of time reading up on investing and follow the steps outlined in this article, you’ll feel in charge of your investment strategy in no time!
Stay tuned for more articles that address the other 5 Financial Must Haves for Gen X and Gen Y.