Investment Basics

Successful investment planning is part of the overall financial planning process. Before you begin to assess specific investment vehicles and decide where to put your money, you need to understand your financial situation fully, develop your goals and establish a timetable to accomplish them. In short, you need to know where you are and how you want to proceed prior to building an investment plan.

Asset classes
Investments can be grouped into three general categories or asset classes:

  • Cash/money market securities - a conservative investment that pays a current rate of interest; often represents a short-term loan to the most credit worthy companies or government agencies.

  • Bonds - represent a loan to a company or a government agency, generally issued for longer periods of time, usually one to 30 years.

  • Stocks - often referred to as "equities," stocks represent ownership of a company and are considered a higher-risk investment.

A diversified investment approach spreads your money among several investment classes and types with different levels of risk. Diversification is based on the likelihood that the market values of some investments in your portfolio will go up while the market values of others go down. It helps reduce overall risk but may not protect against the possibility of losing some or all of the money invested.

Market risk
Market risk means the level that your principal investment fluctuates, causing your shares to be worth more or less than the original cost when sold. Some people can tolerate more risk while seeking higher returns. Others cannot and want more stable returns, even if the total return over time may be lower.

Dollar cost averaging
Choose a consistent amount of money to invest on a regular basis. The process is called dollar cost averaging. When the price of each fund share is low, you'll buy more shares. When shares are high, you'll buy fewer of them. When you sell, you may have purchased more shares for less than if you tried to guess the top or bottom price of the market. Although it cannot assure a profit, dollar cost averaging has proven successful in good times and bad. The longer the period of regular investing, the better dollar cost averaging may help smooth out the cost basis.

Types of mutual funds
"Variety" is a one-word description of investment choices, particularly mutual funds. There are many mutual fund types from which you can choose - conservative, aggressive, income, growth, value, growth and income, balanced, to name a few. Carefully assess investment vehicles before you decide on a specific investment for your plan.

Interest is an amount paid out by people or banks to borrow money. It is commonly represented as a percentage of the principal, or loan amount. There are two types of interest; simple and compound. Simple interest is calculated only on the principal amount, so that $100 dollars at 5% interest would pay $5 each year. Compound interest differs in that it also factors in accumulated interest as well as principal. That same $100 dollars at 5% interest would pay $5 in the first year. But compounded annually, in the second year the interest would be $5.25, because the interest would be calculated on $105, which is the original principal of $100 as well as the accumulated interest $5. All other factors being equal, funds grow quicker when compounded annually rather than with simple interest.

Inflation is the idea that the purchasing power of money decreases over time. Another term, deflation, is the opposite, when the purchasing power of money increases over time. Purchasing power is the relative comparison of how many units of good a unit of money can buy at different periods of time. For example, a dollar bill that once could have bought an ice cream cone loses purchasing power if the price of the ice cream cone increases over time. Because of the effect of interest, we generally expect inflation to occur over time.

Rule of 72
The Rule of 72 is a helpful formula to help you quickly approximate the number of years it will take for a sum of money to double at a given interest rate compounded annually.

Years to double = 72 / Interest rate

In order to approximate how long it would take for an amount to double at 10% interest, you would divide 72 by 10 to get about 7 years. You can rearrange the formula to figure out the rate at which an investment received interest.

In general, there is a noticeable effect to reducing the interest rate. For example, if you were to accept 3% interest rather than 6% interest, you would have to wait approximately 24 years for that investment to double, rather than 12 years. Remember that the rule of 72 is only an approximation.

Need help?
Choosing investments is often difficult. You may want help from a financial planner, giving yourself added opportunity to make informed investment decisions - ones that better help you achieve your financial goals.