“You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” –Warren Buffett
While you don’t need an advanced degree in rocket propulsion to reach your financial goals, investing can feel overwhelming when you haven’t learned the basics. You could even say it’s like being at the controls of a rocket ship hurtling through space. There are lots of lights flashing and you have nary a clue as to what does what. One wrong move could send you off course.
Stay calm. Whether you’re just getting started or need a refresher, here’s a quick crash course on investing basics – all in a few sentences or less – to keep you moving toward the financial life you’ve dreamed about. For the most part, investing is only as complicated as you want to make it.
The difference between a trader and investor
A trader quickly buys or sells investments on a frequent basis in hopes of making a profit. An investor, on the other hand, generally allocates money to certain assets over a longer period of time in order to create wealth for specific financial goals.
What goes into a portfolio?
An investment portfolio typically holds certain investments, or assets, such as stocks, bonds, real estate, cash and alternative investments. Each asset type has its own overall risk and return characteristics and can serve different purposes. Stocks, for example, generally have a higher level of risk and return potential than bonds; therefore, stocks are generally used for growth while bonds can provide stability and income in a portfolio.
What are investment funds?
An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group. These advantages include an ability to: the ability to access a wider range of securities than the investors themselves would have been able to access; the ability to hire professional investment managers, which may potentially be able to offer better returns and more adequate risk management; the benefit of economies of scale, such as lower transaction costs; and increase the asset diversification to reduce some risk. Mutual funds and ETFS are two popular examples of types of investment funds.
Investment costs matter
Given two similar investments, investment costs are a better indicator of future returns than past performance. While you can’t control where markets will go, you can control the fees you pay. A low-cost approach to investing can mean keeping more of your portfolio’s return.
What is risk tolerance?
Determining your risk tolerance is not an exact science. It’s the level of risk you’re comfortable with, that you’re able to take and that you need to reach your financial goals. Remember, you cannot earn a return without taking some risk – there is no free lunch!
What is asset allocation?
How your portfolio is divided among different investments or assets is known as your asset allocation. You should have an appropriate asset allocation that reflects the amount of risk you’re comfortable with as well as has the potential to build enough wealth for your financial goals.
Diversification reduces risk
A well-diversified portfolio holds several different assets with prices that move independently of each other. This helps reduce risk and provide exposure to different areas of growth in the markets because your portfolio isn’t tied to the performance of one particular asset. Diversification is a better alternative to trying to outsmart the market.
Why it’s important to think long term
Markets are volatile in the short term, but over long periods of time they can be relatively stable and predictable. That’s why investors are better off being patient and sticking with an investment strategy as the market works itself out. Research shows investors who change course tend to underperform, which means investors who tune out the noise and stay focused have a higher chance of reaching their goals.
Want to learn more? Find out how to make better financial decisions after reading our free guide, The Pocket Guide to Good Financial Thinking.