Your journey to financial freedom can seem daunting. But remember, you don’t need to be a financial expert. All you need is a solid foundation of basic financial education in order to make wise financial decisions and work effectively with your financial advisors. To steady your course, here are eight basic principles of investing that you should know:
1. There is no single perfect investment
When investing, it is necessary to weigh the advantages and disadvantages of each investment type and to select the investment options that most closely fit your circumstances and personal goals.
2. Risk and reward are proportional
It is important for investors to understand the risk/reward ratio of the investments they currently own and considering to purchase. Generally, the greater the potential reward of an investment, the higher the risk associated with it. Different investment vehicles carry different levels of risk.
3. Minimize risk and maximize reward
Diversification is based on the knowledge that different categories of investments respond differently to the same economic conditions. A strategy for managing risk and boosting returns is to diversify investments across industry and investment types. Asset allocation is an important component of diversification. It involves deciding what percent of your total investment portfolio should be allocated in each of the investment categories.
4. Compounding interest is powerful
Compound interest is growth through multiplication. Interest or earnings deposited back into an investment on a regular basis will increase the size of the asset and its ability to generate still more earnings in the future. According to Jane Bryant Quinn, nationally syndicated financial columnist, “Compounding is a true perpetual money machine.”
5. Pay yourself first
One technique to help individuals spend less and save more is the “pay yourself first” method. That means that with every paycheck, and before any expenditures are made, a predetermined amount or percentage is transferred to personal savings. This assures that saving takes priority and occurs on a regular basis.
6. Practice dollar cost averaging
Dollar cost averaging is investing a fixed amount of money at regular intervals (usually monthly). With this method you will sometimes be buying when prices are high and sometimes you will be buying when prices are low. Over the long-term, your average cost will likely be lower and your return higher than if you tried to time individual purchases to market swings.
7. Avoid market timing
Market timing is an investment strategy that involves trying to outguess market movements. Essentially, it means buying before the market goes up and selling before the market goes down, this strategy rarely outperforms the investor who buys and holds.
8. Maximize tax favored retirement plans
Your best investment “bargains” are tax favored retirement plans. They offer two types of tax advantage: tax deferral and tax deductible. Tax deferral means that taxes are not paid on investment earnings until withdrawal of funds. Tax deductible means that contributions made to a tax favored retirement plan are excluded from your reported income and are thus free from federal and state income taxes. Keep in mind that eligibility requirements vary for these plans and the “tax breaks” they offer.
Reprinted by permission of Money Quotient, NP