By waiting to invest until the market looks attractive to you, you may cheat yourself out if good opportunities. T hat can make a big difference in how much your investment earns. While economic growth can be a result of a positive force, inflation can have a serious effect on investors’ portfolios if their income and investments are not keeping pace. Even at low rates, inflation erodes the purchasing power of money kept in savings accounts or bonds. The prices of many important life goals - a car, a house, or a college education - often rise faster than the rate of inflation.
What you can do to help stay ahead of inflation:
- Start your financial plan early. IT'S TIME, NOT TIMING, that counts when it comes to your investment return. Reinvest all dividends and capital gains in additional shares to accumulate wealth faster.
- Look for investments that have the opportunity to beat inflation. Based on broad stock market indexes such as the S&P 500 and the Dow Jones Industial Average, over long periods of time COMMON STOCKS have outpaced inflation, as measured by the Consumer Price Index.
- DIVERSIFY. As the saying goes, don’t place all your eggs in one basket. A diversified portfolio of funds with different investment styles may achieve growth with less risk.
Understanding Risk and Reward
Every investment choice involves some degree of risk. Therefore, before making any type of investment choice, you need to understand what the risks are and how to balance them against the potential rewards.
What are the types of risk?
- Capital risk: The risk that your capital won’t return intact.
- Credit risk: The concern that the investment’s issuer will not be able to meet its payment. Professional management and in-depth research are invaluable when attempting to manage credit risk.
- Inflation risk: If your investments cannot keep pace with inflation, your money will lose some of its purchasing power. Stock investments are generally considered among the best ways of addressing inflation risk over the long term.
- Interest-rate risk: Since bond prices fall as interest rates rise, this type of risk is a concern for fixed income investors. Interest rate increases can also have a negative effect on stock investments.
- Liquidity risk: Not all investments can be readily converted into cash at their perceived market values.
- Liquidity risk can affect the prices of securities held in the fund’s portfolio and, as a result, the fund’s share prices.
- Market risk: This measures how sensitive securities are to changes in general market conditions. Remember, though, that securities that lose value quickly in market declines may also show the strongest gains in more favorable environments.
- Prepayment risk: This type of risk involves the premature payoff of a loan, with a resulting loss of interest income and exposure to reinvestment risk.
- Reinvestment risk: The risk you won’t be able to reinvest your capital at favorable rates.
The upside of risk:
- No pain, no gain. There is no such thing as a risk-free investment. In order to build assets, you must undertake risk of one kind or another.
- The greater the risk, the greater the potential reward. Greater potential reward is the price the market demands in return for undertaking greater risk. However, taking big risks does not necessarily ensure big rewards. You must know the risks and weigh them against the possible rewards.
The bottom line:
- Choose appropriate risks (finding your sleep threshold). Know and understand the risks involved in various savings and investment vehicles. Make sure you are comfortable with the risk level of the investments you choose.
- Manage risk; don’t try to escape it. Investments concentrated in one investment style may limit performance or increase risk. Asset allocation is a strategy that allows you to balance risk and reward by allocating a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. Please note that asset allocation does not guarantee a profit or protect against loss.
- Maintain a long-term horizon. Many investors recognize that holding their investment for long-term smoothes out the effects of volatility.
How Compounding Works
What is compounding? It is interest earning interest. One of the biggest advantages to compounding is when you reinvest earnings, you buy additional shares. These shares earn dividends that purchase even more shares. The value of your account grows at an ever increasing rate.
Three ways to put compounding to work for you:
- Reinvest dividends.
- Invest regularly. Develop the habit of adding to your investment account on a regular basis. You may be able to have this done automatically by setting up a systematic investment plan.
- Make time your ally. The longer your money can work for you, the better compounding can work for you.
When planning for a long term goal, often it is good to determine how long it will take to double your money, or the rate your investment must earn in order to double within a stated number of years. The Rule of 72 allows you to make this calculation quickly.
To find the number of years, simply divide 72 by the rate. Or, to find the rate at which your investment must earn in order to double in a specified number of years, divide 72 by the number of years.
It is important to keep in mind that most investments do not grow at a steady rate and that the Rule of 72 should only be used as a guide in setting long term investment goals.
The rule of 72 is a mathematical concept and does not guarantee investment results or function as a predictor of how an investment will perform. It is simply an approximation of the impact of a targeted rate of return would have. Investments are subject to fluctuating returns and there is no assurance that any investment will double in value.
Dollar Cost Averaging
Dollar-cost averaging is committing a fixed amount of money to an investment at regular intervals. With dollar-cost averaging you don’t have to outguess the market, you can take advantage of the highs and lows.
A few reasons why you should consider dollar-cost averaging:
- It’s smart. Buying more shares when prices are low and fewer shares when prices are high is a certain way to reduce your average cost per share.
- It’s automatic. Preauthorized checks can be drafted monthly from your personal checking account.
- It’s painless. When you pay yourself every month before you pay the bills, you’ve wisely placed your money in a investment before you realize it was ever there to spend. It’s a smart way to invest long term for your retirement, through and IRA or a 401(k) Plan.
- It’s disciplined. Dollar-cost averaging take the emotion out of investing. You can stop asking yourself, "When’s the right time to buy?"
- Dollar-cost averaging helps you avoid the pitfalls of market timing.
Such a plan involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through periods of low price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
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