Week 6: Making the Right Investment Choices
We have now reached Week 6 of Personal Finance Resolution... congratulations on making it this far! Keeping a New Year's Resolution into February is quite an accomplishment.
Be sure to brush up on all of the previous issues if needed:Week 1: Assessing Your Current Financial Health
Week 2: Setting Up a Budget
Week 3: Establishing Financial Goals
Week 4: How to Get Out of Personal Debt… For Good!
Week 5: Slashing Your Spending & Expenses
Now to the topic for Week 6::
Making the Right Investment Choices
This week's Activities for Success:1) Complete the Risk Tolerance Quiz
2) Use the results of the quiz to determine the types of investments that best suit you
3) Consult a financial advisor to streamline your investing
This Week's Helpful Articles:Getting Started with Investments and Financial Planning
Introduction to Trading and Types of Orders
Types of Retirement Plans
As we have discussed in previous issues, money left over after paying your bills each month should always be first used to pay off any existing credit card debt. Also remember that you should always be striving to have 6-8 times your monthly expenses saved in a "rainy day fund".
The first investment you should always fund is an employer-matched (k). If your company offers to match a percentage of your salary into a retirement account, it is like they are giving you FREE MONEY. Be sure to fully fund these accounts up to the maximum matching percentage that your employer offers (if any) before making other investments.
Next, funds that will not be needed to pay expenses, make near-term purchases, pay off debt, or fund a matching 401(k) can be invested in securities. A good investment will accrue value over time, but in order to take advantage of the opportunity, you must often allow your money to be outside of your direct control for a significant period of time. Otherwise, short-term volatility may erase the benefits of an otherwise sound investment. Therefore, you should only be buying securities like stocks, bonds and mutual funds with money that you will not need in the foreseeable future.
Different investments will be appropriate for different investors. Your age, amount invested, and reasons for investing will have a significant effect on which types of securities you will choose. Once you understand your risk tolerance level, you'll be able to better understand which investments are right for you. Let's start by taking a short quiz about your risk tolerance level.
Now that you have a better idea of where you fall on the risk scale, let's look at some different investment options.
StocksPurchasing shares of stock gives you fractional ownership of the public company in which you have invested. Essentially, at least a portion of the success of your investment will be tied to the success of the company, or, more specifically, to the desire of other investors to own the same company (since in the short term it's investors who collectively determine the share price). If the price of the stock increases, your shares become more valuable and you can sell them for more than you bought them for. If the price of the stock decreases, you shares become less valuable and you will receive less than you invested when you sell.
Additionally, some companies pay a dividend, which is essentially the act of returning a portion of the company's profits to its stockholders. They may be paid either in cash or in the form of additional shares of stock.
Stocks trade on exchanges such as NASDAQ and the New York Stock Exchange (NYSE). Investors can purchase shares through a full-service or discount broker by paying a certain fee (called a commission) in addition to the price of the stock at the time of purchase. The same process is used when it comes time to sell except the shares are exchanged for their value in cash minus another fee. Dividend Reinvestment Plans (DRIPs) are another way to acquire stock. The stock is offered directly by the company and any fees are greatly reduced or eliminated.
Investing in stocks can be quite risky, so it is important to research potential purchases thoroughly in order to identify stocks with the potential to produce significant returns without too much danger of losing value. It is usually in your best interest to hold onto stocks for a year or more. The reasons for this include the fees associated with frequent buying and selling, the tax advantages gained by owning stock for at least one year, and possibly most important, the fact that, in the short-term, volatility may prevent an otherwise good investment from accruing value. Given time, a sound investment may recover from temporary dips.
We recommend a company like ShareBuilder for purchasing stocks.
interest. The rate of interest varies with the probability that the original loan amount will be successfully paid back. Risky loans return more interest, but there is a danger that the borrower will default on the loan and some or all of the original investment will be lost.
In addition to rate of interest, bonds vary in the length of time over which the borrowed money is repaid (called the 'term' or 'duration'). Throughout this duration, the amount of money yet to be returned will earn interest. Some bonds return principal and interest at intervals throughout the term and others return everything at the end of the term.
The value of a given bond changes as prevailing interest rates and the financial health of the borrower change. For this reason, some bonds can be traded on a secondary market before the end of their term.
Generally, bonds are a safer investment than stocks, but, as a result, the prospects for astronomical returns are slim. Also, not all bonds are safe investments, so it is important to research them as thoroughly as any other investment. The safest option are bonds backed by the federal government, which are guaranteed not to be defaulted on. However, because they are so safe, they offer only a modest interest rate.
Because ETFs are traded on stock exchanges, you can buy and sell them at any time during the day (unlike most mutual funds). Their price will fluctuate from moment to moment, just like any other stock's price, and you'll need a broker in order to purchase them, which means that you'll have to pay a commission. On the plus side, though, ETFs are more tax-efficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF.
k) account are mutual funds. Mutual funds pool the money of many investors and purchase investments according to either a predetermined strategy or in an effort to mimic an index, such as the NASDAQ 100 or the S&P 500.
Funds are either actively managed or passively managed. Actively managed funds are run by a manager who chooses when to buy and sell investments in an effort to produce the greatest returns for the funds investors without straying from the general principles that led those investors to sign on in the first place. Passively managed funds (called 'index funds') simply hold securities in the same proportions as the indices they seek to mimic, and buy and sell investments only to maintain the proper composition and balance.
Mutual funds offer several benefits to investors. Most importantly, individuals can invest in a broad cross-section of stocks and bonds without needing enough money to invest in each security individually. This diversification protects against isolated volatility and allows investors to bank on safer entities like a sector or certain size company instead of banking on the success of a single company. The price for these advantages is often the fee required to buy or sell shares of a mutual fund and the percentage of returns that are paid as expenses to the operators of the fund. However, some funds, and especially exchange-traded funds, eliminate a great deal of the fees involved and allow investors to buy in with minimal extra costs.
If all of this is too much to digest, we suggest you look into low cost target retirement funds, e.g., those sold by Vanguard. These funds will automatically change the asset allocation based on the retirement date and require less monitoring and maintenance.
After reading through these different types of investments and taking the Risk Tolerance Quiz, you will have a good idea of what types of investments you should be looking at. Remember, with any investing there is risk involved, so if you are unsure of where to invest, speak to a financial advisor.
1. Complete the Risk Tolerance Quiz
This week's Activities for Success:
2. Use the results of the quiz to determine the types of investments that best suit you
3. Consult a financial advisor to streamline your investing
Terms Used in this Issue:(k)
New York Stock Exchange(NYSE)
Dividend Reinvestment Plans (DRIPs)
Stay tuned for next week's issue, which will cover The Fool-Proof Guide to Taxes.