Investments
Posted on September 8, 2008
Filed Under Free Financial Course |
The key to choosing investments is to understand that: the higher the risk, the higher potential return. However, riskier investments also have a higher potential loss.
What is Your Risk Tolerance?
So, before investing, you first need to determine what your risk tolerance is. Your risk tolerance is how much risk you are willing to live with in order to have a chance at a possible return.
Your risk tolerance can be determined by a number of different factors:
- How long are you going to invest? (Longer time = higher risk)
- How much money can you afford to lose? (Higher amounts = higher risk)
- What are your financial goals? Specifically, how much money do you want to accumulate in a certain period of time? (The higher return required = higher risk).
- What is your personal preference (i.e., Are you content to wait, hoping that an investment that drops in value will rise again?) (More patience = higher risk)
- Where is your personal comfort level? (If you are willing to “live on the edge” = higher risk).
You should choose investments that match your risk tolerance. Even though certain investments may earn more in the long run; you need to be able to cope with the fluctuations that are a part of investments.
Types of Investments
There are literally thousands of things you can invest money in. This is not a comprehensive list; however, this is a list of a few major types of investments, along with a brief explanation of their risk levels.
- Savings account. A typical savings account at a bank is a very low risk investment, but also has very low returns. These accounts are typically FDIC insured up to $100,000 (meaning that the government insures your investment up to $100,000); however, the return is usually less than 2.5%. Still, you can find some savings accounts that offer higher returns. For example, E-loan offers much higher rates on an FDIC insured savings account, than most traditional banks. This could be one good option to upgrade your savings account.
- Money Market Funds. Most banks offer a money market savings account. These accounts are not FDIC insured, but typically will earn you a higher return. The bank invests this money in very low risk investments and in exchange, the bank pays you a small return, typically around 3 to 5%.
- Certificate of Deposit (CD’s). Most banks or brokerage firms can offer a range of CD’s. The return is typically determined by the amount you are willing to invest, and the length of time you are investing for. The more you invest and the longer the term, the higher the return. The downside to CDs is that you are penalized if you pull your money out early. So, if you open a 6-month CD, make sure that you will not need the money before the term is over. The typical return on a CD is anywhere from 1 to 6%.
- Bonds. A bond is essentially a loan to someone else, usually a municipality. For example, let’s say the city of San Francisco needs $100 million dollars to build a new bridge. They will ask the public to loan them money in the form of bonds. If you invest $100,000 in these bonds (loaning San Francisco $100K), and the bond has a term of 20 years, then San Francisco is required to pay your money back at the end of the term. In addition, a bond will pay a “coupon payment”, typically every six months. The coupon payment gives an average return on the investiment of around 6%. Therefore, for a bond investment of $100K at a 6% return, each year you will receive a payment of $6,000 ($3,000 every six months). For this reason, bonds are referred to as “fixed income” investments, because your payment is fixed no matter what happens to the value of the bond.
- One of the risks of investing in bonds is that the issuer (San Francisco) may not be able to make the payments, or may go bankrupt. To help investors determine how risky a bond is, Standard & Poors (S&P) and Moody’s rate the risk level of a bond. The higher the rating, the lower the chance that the issuer of the bond will default. For example, S&P rates bonds AAA (lowest risk), AA, A, BBB, BB…to D (highest risk). Investors typically invest in bonds for the income or to even out the fluctuation that stocks have. Bonds with a good rating are considered a very low risk investment.
- Stocks. A share of stock in a company is a portion of ownership in the company. Therefore, if you purchase a share of stock in McDonald’s, you actually own a small portion of McDonald’s. Stocks are considered more risky than bonds and are not FDIC insured. The riskiness of a stock is determined by the company that you have invested in. Therefore the return can vary greatly. You could lose all of your money in a stock, or you could receive a 10,000% return on your investment. The average S&P 500 (the largest 500 stocks) return over the past 30 years is around 12%. The average small cap (small companies) return is closer to 17%. However, these small companies are much riskier. Because investing in stocks can be a risky venture, it is wise to consult an investment advisor for guidance on how to invest in stocks.
- Mutual Funds. A mutual fund invests in a group of stocks in order to diversify the holdings, and thereby reduce the risk. An individual can purchase shares in a mutual fund. These shares will be divided among all the stocks within that mutual fund. Therefore, one share of a mutual fund may actually own a fraction of 10 or more different shares of individual stocks. Mutual funds are typically less risky than stocks; but often have a lower return. A mutual fund that consistently returns greater than the S&P 500 (12% over the last 30 years) would be considered a great mutual fund.
- Real Estate. Investing in your own home is certainly important; however, investing in real estate overall can be a very wise venture. Real estate investing may include rental properties, land, development, “flipping” homes, commercial properties, and many other options. The average annual return on a residential home in the US (depending on loacation) is 1 to 6%.
As discussed, there are a large number of other types of investments; however, the ones mentioned will allow you to obtain great personal wealth.
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