Last week, I discussed how to invest so now I want to give you some things to consider before you actually do invest.
An excerpt from The Graduate’s Guide to Money:
Classification of Mutual Funds
There are stock funds and bond funds. There are funds that focus on a particular market segment, such as health care or high tech, and funds that are geared toward growth or income. If you can think of a classification or category, there is probably a mutual fund focused on it. Just about every investing objective can be covered through a mutual fund.
The three critical factors to consider when answering this question are:
- How much time do you have before you need access to the investment proceeds?
- This is called the time horizon.
- The longer the time horizon, the more risk you can take with the investment (equities). The shorter the time horizon, the more conservative you want to be (guaranteed interest, bonds).
- What is your investment objective?
- If you need to purchase a house in five years, for example, safety of your principal is very important. On the other hand, if you are investing to create financial independence in 50 years, you might select very different types of investments than when you are saving for a specific purchase or event, because you can weather more ups and downs in the market.
- Consider whether you have a growth objective or an income objective. For growth, you want appreciation of the investment over time. For income, you want the investment to give you cash flow on a periodic basis (like paying you interest or dividends).
- What is your risk tolerance?
- Risk is tied to the previous two factors: Objective and time horizon.
- The bigger the swings in highs and lows of the stock price over the short term, the more volatile the investment is, and generally the more risk it carries. Risk tolerance is also emotional, to an extent. Here is where you need to examine your tolerance for risk. Ask yourself, “If I lost 25 percent to 40 percent of this investment in the short term would I be able to continue adding money to it knowing that over the long term, it will recover and the investment could grow?”
- You must have that attitude in order to take on the volatility of equities. If the answer is “no.” (for example, if this money is for a down payment on a house in a year), you should not invest that money in equities. Your risk tolerance for that pot of money is too low for equities.
- The key to managing your risk tolerance is to be very clear about what this investment is for (emergency savings, down payment on a house, college education for your 1-year-old, or financial independence). You should also understand that over long periods of time, the intermittent highs and lows are less of an issue allowing you to see the overall upward trend in the market. So, in the long term, take on the risk of equities; in the short term, don’t. Once you get that in place, do your best to manage your emotions. When the market goes up 25 percent in a year, that’s nice. When it goes down 25 percent in a day, hold tight and know that it will come back up.
Next week, we’ll talk about understanding the risk inherent in an investment.
To your financial success,