How To Choose Your Investments: A Guide
Choosing investments is an interesting exercise because it is both simple and complicated at the same time. While the very basics of investing are easy — deposit money into an account; pick the stocks, bonds, mutual funds or other investments you want; and buy them — there are many factors that go into investing successfully. In that way, investing is part art, part science. While the same basic investments are available to everyone, the way you put them together will define how well they serve you. Here are some of the most important factors you should consider when choosing investments.
Investment Objectives
It’s hard to pick investments without knowing what you want out of them. Investment objectives are the first step in guiding you in the right direction. Typically, investment objectives cover wide categories such as income, growth or a combination of the two.
Growth-oriented investments, like certain stocks, don’t pay dividends and seek to maximize capital gains. Growth investments can generate outsized returns, but they also tend to be more volatile.
Income investments, like bonds and preferred stocks, don’t generally appreciate in value much, if at all, but they pay a steady and predictable stream of income.
Growth-and-income investments, as the name suggests, attempt to generate both capital gains and dividends or interest payments. Sometimes a single investment can be considered a growth-and-income investment, like a high-dividend-paying stock, while other times it takes a combination of investments to generate a growth-and-income portfolio.
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Risk Tolerance
Risk and reward go hand in hand in the investment world, and it’s important to decide early on just how much volatility you can handle in your portfolio. While it’s easy to say that you can handle a 50% drop in your portfolio, it’s a lot different actually going through it. Sometimes it takes going through a bear market to find out exactly how much risk you can actually take. If you think you need aggressive growth stocks to reach your retirement goals, for example, but you get sick to your stomach at every 10% decline, you might consider dampening down the risk in your portfolio so that you can sleep at night.
Time Horizon
The final cornerstone of an investment plan is your time horizon. The shorter your time horizon, the less risk you should take in your portfolio. This is simply because you’ll have less time to recover from any significant downturns. If you bank your whole portfolio on aggressive growth stocks but you need your money in one year, you might be forced to sell right in the middle of a bear market, when some of your individual stocks may be down 50% or more. If you have a 20-year time horizon, however, you can generally be more aggressive. In fact, the longer you look out, the less risky the stock market becomes. The S&P 500, for example, has never had a 20-year period in which it has lost money, no matter how volatile it can be on a day-to-day basis.
Putting It All Together
Now that you’ve got your financial road map in place, it’s time to implement your investment strategy. Speaking with a financial advisor is helpful in getting you to where you want to be, but if you want to go it on your own, here are the final steps you should take.
Pick the Right Broker
The right broker can make or break your investment portfolio. You’ll have to determine which broker gives you the best combination of service, execution, product, and cost for your needs. A zero-commission broker, for example, can be a good option if you understand what you’re buying and selling — and if you trade frequently — but it may not be able to provide you with comprehensive financial planning. You might also be tempted to overtrade. A full-service broker, on the other hand, might be able to help you with advanced financial planning topics, but you’ll have to pay fees that are sometimes quite high, and that can drag down your investment results.
Diversify Your Investments
While you can bet your whole portfolio on a single investment that you think is a winner, the downside generally far outweighs the upside. With that type of investment strategy, all it takes is a single loser to wipe out your entire portfolio. At least when you’re starting out, it’s best to diversify your portfolio, both in terms of asset class and investment sectors. For example, you’ll likely want to sprinkle some bonds or more conservative investments among your aggressive growth stocks, and you should generally add some small- and mid-sized companies among your portfolio of giants. What you’re trying to find through diversification is the right blend of investments that keeps both your investment objectives and your risk tolerance in balance.
Monitor, Update and Rebalance
Once you’ve created and implemented your financial plan, congratulations! But remember the work isn’t done yet. You’ll have to monitor and regularly update and rebalance your portfolio to keep it in line with your original plan.
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