by Stacy Francis, CFP®, CDFA
If you're a novice investor -- or you're looking to brush up on a specific investing concept -- this is the article for you. Savvy investing requires knowledge of several key financial concepts as well as an understanding of your personal investment profile.
The Difference Between Saving and Investing
Even though the words "saving" and "investing" are often used interchangeably, there are differences between the two.
Saving provides funds for emergencies and for making specific purchases in the relatively near future (usually three years or less). Ease of converting to cash is an important aspect of savings. Dollars used for savings generally have a low rate of return and do not maintain purchasing power.
Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk.
Total return is the profit (or loss) on an investment. It is a combination of current income (cash received from interest, dividends, etc.) and capital gains or losses (the change in value of the investment between the time you bought and sold it).
ALL investments involve some risk because the future value of an investment is never certain. Risk, simply stated, is the possibility that the ACTUAL return on an investment will vary from the EXPECTED return or that the initial principal will decline in value. Risk implies the possibility of loss on your investment.
The Risk / Rate-Of-Return Relationship
Generally speaking, risk and rate of return are directly related. As the risk level of an investment increases, the potential return usually increases as well.
You can do several things to offset the impact of some types of risk. Diversifying your investment portfolio by selecting a variety of securities is one frequently used strategy. If you put all of your money in one place, your return will depend solely on the performance of that one investment. Alternatively, if you invest in several assets, your return will depend on an average of your various investment returns. Here are three basic ways to diversify your investments:
Variety of Assets - By choosing securities from a variety of asset classes, e.g. a mix of stock, bonds, cash and real estate
Variety of Securities - By choosing a variety of securities or funds within one asset class, e.g. stocks from large, medium, small and international companies in different industries
Variety of Maturity Dates - By choosing a variety of maturity dates for fixed-income (bond) investments.
Another technique to help soften the impact of fluctuations in the investment market is dollar-cost averaging. You invest a set amount of money on a regular basis over a long period of time, regardless of the price per share of the investment. In doing so, you purchase more shares when the price per share is down and fewer shares when the market is high. As a result, you will acquire most of the shares at a below-average cost per share.
As most investors know, market timing . . . always buying low and selling high . . . is very hard to accomplish. Dollar-cost averaging takes much of the emotion and guesswork out of investing. Profits will accelerate when investment market prices rise. At the same time, losses will be limited during times of declining prices.
The Time Value of Money
Now that you understand the concepts of risk and return, let’s turn to an element that is at the heart and soul of building wealth and financial security...TIME. The essence of the concept time value of money is that money is worth more now than in the future.
Compounding also applies to dividends and capital gains on investments when they are reinvested.