Following down the steps to investing
, we’ve reached Step 6: Learn the investment choices that are right for you. Choosing the right investments involves your time frame, your tolerance for risk, and how much of your personal time you want to devote to investing. Let’s look at each of those factors.
Time frame: The longer your time frame, the more volatile investments you can make since the long investment horizon will even out the risk. If you’re investing for many years, you need to invest in things that will return more than inflation, which means stocks, bonds, and real estate. If you’re investing for a short period of time (a few years or less), you need to be in assets that have a relatively guaranteed return, such as bank CDs, money market funds, and short-term bonds. In general:
If you are investing for less than 5 years, avoid stocks, and only hold short-term bonds, if any.
If you are investing for five to ten years, tilt towards bonds, blue chip company stocks, and real estate investment trusts, with bonds making up the majority of the portfolio.
If you’re investing for ten years or more, you should be in growth stocks, medium to long-term bonds, and real estate with the majority on stocks.
Risk tolerance: If you’re investing for twenty years or more and have a gut of steel, you should be invested entirely in stocks, and mainly growth stocks, since that will provide the greatest return. You can also put some money into individual stocks if you want to enable the chance of having really great returns by picking a great stock or two that trounces the market. If you get worried every time your portfolio value dips, however, or if you aren’t in a position where you can take too much risk (like you have just enough to retire and no back-up plan), you’ll need to cut your risk down a bit by adding some fixed income assets like bonds.
For some individuals, seeing a decline in their portfolio value at all causes a great deal of stress, so they might be tempted to leave everything in bank assets like CDs. Still some equities should be bought if you have a long time horizon. You might take the risk of seeing a decline in your portfolio value from time to time, but those losses are quickly made up if things are just left alone to recover. If you have your money in the bank, you’ll be guaranteed to lose purchasing power every year due to inflation since bank rates are always a percentage point or two behind inflation. Over a period of many years, the losses will be significant, so you’ll be guaranteeing that you’ll lose money.
100% investment in stocks will provide the greatest return over long periods of time (like 15 years or more), but adding just a little bit of bonds and REIT shares will reduce volatility – the size of the swings in value – substantially while only giving up a little bit of return. Adding 20% bonds and 10% REIT to a portfolio of growth stocks, for example, can be a good trade-off for those who don’t enjoy roller coasters in their investments. Using mutual funds instead of individual stocks, and buying different types of funds, such as large caps, small caps, international, growth funds, and value funds, will also help reduce price swings.
Time required: Very little time will be required to invest if you invest only through mutual funds. You just need to spend a little time choosing which fund family you will use and setting up an account. After that, you just spend a few minutes each year rebalancing things. If you invest solely in index funds and ETFs, and don’t sell shares very often, you also won’t need to worry about filling out tax paperwork for stock gains every year since they will create little or no income.
If you choose to invest in individual stocks, more time will be required to prune and manage your portfolio. If you invest in the strategy I can serious investing, where you pick a few great stocks and plan to hold them for really long periods of time, the time commitment required will be minimal after you spend some time assembling your buy list. If you invest like many people, trying to trade and beat the market through timing, quite a bit of time will be required both to mind your portfolio and to fill out tax paperwork. Frankly, this isn’t worth the time involved and you’ll do better just buying index funds than you will by trying to trade stocks and time the markets, but some people like the entertainment value.
So, time frame, risk tolerance, and the amount of time you’re wanting to commit to investing are all factors when choosing the right investments. This choice is personal since everyone has a special situation. If you aren’t sure of how you’ll handle risk, wade in slowly, building your portfolio a little at a time, until you find the mix that’s right for you.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.