Thursday, 29 October 2020

8 Financial Concepts to Master Before You Start Investing

8 Financial Concepts to Master Before You Start Investing
05 Feb
4:58
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If you think investing is a daunting topic — especially when you’re just getting started — you’re not the only one. About 60% of adults say investing in the stock market is “scary or intimidating,” according to a survey from Ally Invest.

It can seem like there’s a lot to learn (and there is), but you don’t have to learn everything right away. Grasping a few basic financial concepts can help you feel more comfortable diving in.

Here’s what you should understand before you get started.

8 financial concepts to learn before investing

1. Diversification is your friend

Diversification is essentially the idea that you shouldn’t put all your eggs in one basket — but with an investing spin. Consider a business that sells sunscreen. It does well during the sunny season, but come rain and snow, sales drop. If you want to see steady returns on your money, you should invest in the business that sells sunscreen and the business that sells winter gear.

“You want to own a portfolio that’s going to do well regardless of the market conditions and economic conditions,” said Thomas Rindahl, a financial planner in Tempe, Ariz. “And because we don’t know which sector of the market is going to do well in any given year, you want to include a little bit of everything in your portfolio.”

That way, when one area is doing poorly, another area might do well, and your portfolio will be less volatile and more consistent overall.

2. Risk tolerance is personal

If you’re aggressive with your investments — meaning you take a lot of risks — there’s the potential to see high returns. But there’s also the potential to see big losses. Assessing your risk tolerance is about figuring out how you feel about the possibility of losing money and investing accordingly.

“In 2008, depending on which sector of the market you were in, you lost 20% to 50% of your portfolio value,” Rindahl said. “If that’s going to keep you up at night, you don’t necessarily want to be high-risk. You must figure out what level of volatility in that portfolio you’re able to stomach.”

Generally, the more money you have in stocks, the riskier your portfolio; the more you have in bonds, the more conservative your investment. Most experts recommend that younger investors take some risks by putting more money in stocks since they have plenty of time to recover from a market dive before retirement.

3. Timing the market is really hard to do

Timing the market is the act of trying to buy and sell stocks based on what you expect the stock market to do in an effort to maximize your returns.

“Beginner investors should understand that they cannot time the market,” said Chris Chen, a financial planner in Waltham, Mass. “People have tried. Most have failed. And those who have succeeded have a really difficult time repeating it.”

Chen pointed to data showing that investors who try to time the market don’t do so well. “From 1998 to the end of 2017, the S&P 500 returned 7.2%, and that’s going through the internet bubble in the early part of the century and the real estate issues that we had in 2008,” Chen said. “According to the same data, the average investor between 1998 and 2017 averaged 2.6%. That is a direct result of wanting to try to time the market.”

Few are lucky enough to strike it rich with a fortunate stock pick, so your efforts may be better spent focusing on your long-term investment strategy.

4. Compound interest is a big deal

You’ve probably heard that the earlier you start investing, the better. That’s because of the power of time and compound interest. Compound interest is what happens when the interest or dividends an investment pays out are reinvested in the portfolio, purchasing additional shares that also can continue to grow and pay out.

“What you’ll see is an ever-increasing growth rate of amount of interest and dividends that are paid out over time,” Rindahl said. “Because of the reinvestment back into the principal, the investment grows exponentially as time goes on.”

For instance, if you put $1,000 into an investment earning 6% a year, in 40 years, you’d have more than $10,000. Add $50 a month to that investment, and you’d have more than $100,000 in 40 years.

5. Fees can make or break your strategy

Cost is an important metric when it comes to the performance of your investments. The more fees you pay, the fewer dollars end up in your account. When you evaluate investments, pay attention to the expense ratio, which is the cost to run that investment each year.

If a mutual fund has an expense ratio of 1%, for instance, that means you’ll lose 1% of the fund’s assets to expenses each year, decreasing your earnings. The lower the expense ratio, the more returns you’ll keep in your own pocket.

“If you remove cost, your investments are going to perform better,” Chen said. “And over time, the compound effect of the savings will be worth a lot of money.”

Other fees could affect your bottom line as well, such as:

  • Sales loads: These are fees assessed on some investments when you buy them or sell them (or both).
  • Surrender fees: Some investments charge a fee if you sell them within a specific time frame.
  • Transaction fees: At some companies, there are costs involved in the buying and selling of investments.
  • Advisory fees: If you’re working with a financial advisor, they may structure their fees in a variety of ways. They might charge by the hour, by the service or by a percentage of your portfolio.

Ask your brokerage company or financial advisor for a full fee schedule, and make sure you understand how the fees work for your investments.

6. Dollar cost averaging could pay off

Dollar cost averaging is the practice of investing a set amount in the market on a schedule — like you do when you make a 401(k) contribution every payday or when you automatically put $100 into an IRA every month. Because the market fluctuates, that money will buy different amounts of investments each time.

“Certain months, you might be buying 10 shares of an investment, other months 12 shares, other months eight shares,” Rindahl said. But because you’re buying a consistent dollar amount every period, you’re purchasing fewer shares when the price is high and more shares when the price is low — smoothing out the volatility and risk overall.

7. Invest for the long term

Investing now — especially when you’re young — isn’t really about what your investments do this year or even what your investments do over five years; it’s about what your investments do over decades. Setting early expectations for your portfolio and pulling money out of the market during a dive will only hurt you in the end, Chen said.

“There are months and years when the market will go down, but in the long run, it’s almost always positive,” Chen said. “From 1927 to 2018, if you bought the S&P 500 and held it for one year, it’s been positive 73% of the time. If you look at 10-year holding periods, it’s been positive 95% of the time. If you look at 20-year holding periods, it’s been positive 100% of the time.”

8. Tax loss harvesting could be a valuable tool

Tax loss harvesting is the practice of selling off your losing investments to counteract any taxable gains you may have in your portfolio. This is primarily a concern if you’re investing in a taxable account — where if you realize a gain on an investment, you’ll pay taxes on it. If you have $1,000 in gains, for instance, you might owe 15% in capital gains taxes, or $150. (Your rate varies by income level.) But if you can sell another investment that’s lost $1,000 in value, you’ll offset the gain and owe no capital gains tax.

“It’s about making your portfolio as tax-efficient as possible,” Rindahl said. “To minimize that taxable gain, you can offset it with enough stock losses for the year.”

Getting started in investing may mean getting familiar with some concepts you’ve never heard of before — but it’s not unmanageable. Once you’ve got the basics down, you’ll be better prepared to create a portfolio that works for you. If you have more questions, a chat with a financial advisor can help you draft the right investment plan.

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Kate Ashford

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