The act of allocating resources, generally money, in the expectation of earning an income or profit is known as investing. If you are handing over your money to a company, financial institution, or the government with the hope of getting more money in the future, you are investing. The objective is to invest your funds across different asset classes and allow them to grow over time. This means you keep a part of your earnings separate and invest it to reap future rewards. Investing acts as a means of ensuring future financial security that enables you to achieve your goals such as buying a home, saving for your child’s college tuition, creating a retirement corpus, etc.
Investing, unlike saving or trading, involves putting your money away for a long period of time. It does not involve trading in stocks on a regular basis. Also, investing differs from saving due to the inherent risk factor. Savings refers to your in-hand funds or money kept safely in your bank account. It constitutes low risk. Investments, on the other hand, carry relatively more risk. Here, your funds are used to generate future returns for you as a source of additional income or profit. For example, if you invested $10,000 in the S&P 500 index 50 years ago, you would have almost $1.2 million to show today for the investment made five decades ago. If you only focus on saving your money, you would hardly have more money compared to what you put away. Hence, it is critical that you invest your money to ensure that it grows. Do not wait. There is never a right time to invest. Start investing as soon as you can so you can work towards achieving your financial dreams.
Investing can be a challenging proposition, especially for beginners. It is dynamic and continuously evolves. In many ways, investing is like learning a new language. It can be overwhelming for people who are just starting and learning the basics of investing. But if you put in effort and time to learn the essentials of investments, basic principles, and the different types of investments, it can prove to be advantageous to you in the long run. There is a specific risk bar, return standard, investment horizon, etc. associated with each investment category. It is imperative that you understand these options and select investment categories that suit your age, income, and return and risk expectations. You can engage a professional financial advisor to better understand the basics of investing, the different asset classes and how you can invest in them, various kinds of investment strategies, and so on.
To make informed decisions while investing, let us first understand the following information on investing:
Why is investing important?
Before you begin investing, you need to first understand the reasons that justify the need for investing:
1. Investing helps build wealth
Through investing you can fund your long-term goals, such as building a retirement corpus, funding a child’s higher education, etc. Investment products are structured in a manner that keeps your money invested for a long period to enable you to earn a high rate of return. Even a slight difference in your rate of return can result in an exponential effect on your wealth accumulation and your financial goals in the long run.
2. Investing helps you harness the power of compounding
Simply speaking, compounding refers to a process wherein an asset’s earnings (in the form of either capital gains or interest) are reinvested to generate further earnings over time. The power of compounding can boost your investment growth significantly. The trick is to start investing at a young age or as early as possible to reap the rewards of the power of compounding. You can also consider automating your investments by setting up a pre-authorized payment plan. Herein, you can regularly invest money towards your chosen investment categories, such as mutual funds on a weekly, monthly, quarterly, semi-annual, or annual basis.
3. Investing helps offset the impact of sharply rising inflation
Inflation refers to the rise in the price of goods and services due to a reduction in the purchasing power of a given currency over time. With a rising rate of inflation, the prices of goods and services rapidly increase leading to a drop in the number of goods and services that you can buy in the future compared to today. The purchasing power of cash is reduced over time due to inflation. To counteract this, you would ideally require your investments to give you a return higher than the inflation rate. You can do so by investing your money in the right investment categories that would enable you to outpace inflation. However, keep in mind that some investments may carry a higher risk than putting your money in a savings bank. But investing in such assets can allow you to generate high returns that can offset the impact of inflation eventually.
What factors should you consider before investing?
Once having understood the advantages of investing, you need to assess how you can make informed investments. To build a successful investment strategy, you would need to first understand your financial situation clearly. Let us discuss some factors you should consider before investing:
1. Create a budget
First, you need to have a budget. This can be a great help in getting a handle on your earnings, spending, and savings. Having a budget allows you to identify how much funds you have available to invest. By creating a budget, you can also determine the areas where you are overspending and reduce your spending to invest more of your funds.
2. List your financial goals
Herein, you set your financial goals and find out how much money you require to achieve those goals. Say, you wish to start saving for retirement and build a corpus, then you first need to find out how much money you need to maintain a similar lifestyle during your retirement years in the future.
3. Identify the reasons behind why you wish to invest
Find out why you wish to invest. You can have different objectives that may pus you to invest your money such as wanting to grow your funds, build a separate stream of income for retirement, preservation of capital to earn interest, etc. After you have determined your investment objective, you can choose an investment instrument that will help you achieve your objective.
4. Determine your investment horizon
Every financial goal has a different time horizon. This plays a critical role in determining your choice of investment vehicle. If you wish to achieve a short-term goal, investing in instruments that ensure liquidity and carry low-risk such as certificates of deposits would be a good investment option. On the other hand, if you wish to invest for the long-term, then instruments such as stocks, bonds, mutual funds, etc. would be a better investment. Doing so would allow you to weather market downturns effectively and offset the loss with recovery profits in the long run.
5. Find out your degree of risk appetite
Risk appetite refers to the degree of variability in returns that you can withstand or absorb i.e. your ability to endure a financial loss in investing. If you have a low-risk appetite, investing in bonds, fixed income securities, etc. would be a better investment choice for you. However, if you favor a high-risk appetite, stocks, equity mutual funds, etc. would be ideal for you. You can also combine both kinds of investments – stocks, bonds, alternative assets, mutual funds, etc. to build a balanced portfolio. Doing so would allow you to hold on to your assets even during market fluctuations. Age also plays a critical role in determining your risk tolerance. For example, you may have a higher risk tolerance during your younger years, but with advancing age as you near retirement, your risk tolerance may drop, and you may choose to focus on capital preservation rather than capital growth.
It is advised that you review the risk parameters at least every year or so or when you cross a significant life stage such as getting married, having a baby, a divorce, or remarriage. This would ensure that you hold investments that are in sync with your financial goals, investment objectives, time horizon, and risk tolerance. If you wish to carry out a goal-based review and identify suitable investments that match your financial goals and risk tolerance, consider consulting with a financial advisor.
What are the different kinds of investments?
Let us discuss some of the most popular investment categories and where they weigh on the scale of risk:
1. Cash and cash equivalents
The safest form of investment category for investors is a bank deposit. It is simple, easy and you know exactly how much interest you will earn and are assured of your capital. You are at no risk of loss. But the interest accrued on a bank deposit is significantly low and insufficient to beat inflation. You do however have the option of investing in cash equivalent instruments, such as Certificates of Deposit (CDs). CDs are liquid assets having a lock-in period (ranging from months to years) that offer a higher rate of return than a savings account.
A bond is a debt instrument that serves as a promise by the borrower to pay the lender the investment principal plus interest on a loan. It is issued by a company or an institution, such as the government, municipalities, states, or sovereign governments to finance projects and operations owned by them. A bond is a fixed-income instrument that has a maturity date specifying when the loan principal is due to be paid to the lender. It also includes the rate of interest, and payment terms, such as variable or fixed interest payments. Bonds are considered to be a safer investment compared to equities especially government and municipal bonds. They offer security at reasonable risk. Bonds are considered to be a good investment instrument irrespective of risk tolerance or life stage. Though, you shouldn’t put all your eggs in the bonds basket. Create a mix of bonds with other money market instruments to earn better returns. A bond-heavy portfolio would only offer moderate returns that would be insufficient to beat inflation and achieve your financial goals. With that said, if your investment objective is to create a fixed income for your golden years, bonds can prove to be a good investment.
3. Exchange-traded stocks (ETFs)
ETFs consist of a mix of stocks, bonds, commodities, currencies, or a combination of them all that offer attractive returns. They carry moderate risk and allow you to invest in a mix of securities traded on a stock exchange. If you purchase an ETF, you invest in a basket of securities rather than any security individually. Investing in ETFs in your portfolio allows you to diversify your investments at a low cost and is considered to be a good option if you have ten years or more until retirement.
4. Mutual funds and index funds
Mutual funds are an investment instrument that allows you to hedge against market volatility and diversify your portfolio. They generate attractive returns by investing funds in bonds, stocks, and other assets, per the investment strategy. Herein, returns are generated based on a mix of securities like equity mutual funds, bond mutual funds, balanced funds, etc. Whereas, if you invest in index funds, they track a specific market index, such as the S&P 500 and Dow Jones Industrial Average. Considered to be ideal for young and mid-age investors, index funds provide broad market exposure that works to generate returns equal to the market index
Stocks are one of the most popular and high-risk investment instruments that offer the highest returns on your money. They carry a high degree of risk. However, you can offset the risk by diversifying your portfolio with different kinds of investments. Doing so can allow you to generate significant wealth over time. It is advised that you invest in stocks if you are young or have a high-risk appetite as they are subject to high market volatility. Investing part of your money in stocks can help generate adequate returns to beat inflation in the long run. Financial experts advise altering your stock allocation with age to balance out the risk and reward with each life stage. The best way to allocate your equity is to subtract your age by 100. For instance, if you are 65 years old, you could allocate 35% in equity and the rest in other stable investment categories.
6. Alternative assets
Alternative assets are those investments that do not fit into the conventional category of investments such as equity, bonds, and cash. They are high-risk instruments that can potentially generate exponential returns. Real estate, Real Estate Investment Trusts (REITs), hedge funds, commodities, private equity funds, currencies, etc. are a few of the most popular kinds of alternative assets. You should keep in mind that each alternative asset carries an inherent risk degree and works differently compared to one another.
What are some common investing tips for beginners?
Investing is a complicated affair and involves various kinds of investments and opportunities. Let us go through a few investing tips for beginners:
- Understand what investment terms such as risk, return, liquidity, diversification, etc mean so you can become familiar with the jargon.
- Begin investing as soon as you can, the younger the better. If you invest even a small sum each month, you can benefit from it in the long run.
- Identify the right asset allocation for you based on your age, time frame, risk tolerance, and financial goals.
- Focus on diversifying your investments in your portfolio. Regularly manage, monitor, and rebalance your investments to align them with your changing risk tolerance, life stage, and financial goals.
- Do not make decisions based on emotions. Invest with a view to stay in the market for the long-term and avoid making hasty decisions during times of market volatility.
- Be open to engaging the services of a professional investment advisor who can help you design an investment portfolio that is focused on achieving your goals, is optimally diversified, and suits your risk appetite.
To make rational financial decisions, you need to first understand the basics of investing. Your decisions should be free from emotional bias and focus on achieving long-term accumulation of wealth and financial security. Investing is challenging no matter whether you are a seasoned investor or a beginner. It is advised that you seek help from an experienced professional financial advisor who has the right investment expertise to build a favorable investment portfolio.
If you wish to learn about which assets to invest in and how to create an investment portfolio that would help you achieve your financial needs and goals, use Paladin Registry’s free advisor match service. Our free match service connects you with 1-3 background-verified financial fiduciaries. You may also set up a free initial consultation with them before deciding to hire one.
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