Investing is murky business, like swimming through cloudy waters. Without goggles. In the dark. With seaweed grabbing at your ankles and trying to pull you down. Anyone can get turned around in those algae infested pools. In fact, you might be thinking of turning right back around for shore and giving up investing for good. But, don’t. Learning how to invest isn’t as hard as it seems. Once you get through the murky parts, such as these often daunting and confusing investing terms and questions, you’ll be paddling like a pro in no time.
Here are the 9 common investing questions answered:
- What is diversification?
Diversification means not putting all your eggs in one basket. Metaphors are fun but what exactly are these baskets? They’re the adjective of describing your investment such as large-cap stocks or tech equities. Diversification isn’t about how many investments you own but rather how those investments work together. You could own 20 companies but if they all make shoes, you’re not diversified because bad news for the shoe industry will take out your whole basket. Diversification means your investments won’t all move together. So, if all your investments are up, you better diversify before the next shoe fiasco hits.
- How do I rebalance my portfolio?
Rebalancing is like maintaining your garden; when certain areas get overgrown, you trim them back. And when growth in other areas lags, you feed them more. Just like your garden, your portfolio can grow more in some areas than others. When you rebalance, you take from the overgrown areas to feed the undergrown ones. To do this, you sell enough of your gainers and buy enough of your ‘laggers’ to bring them back to the original ratios you intended. And like gardening, your portfolio need to be balanced regularly – annually, semi-annually or quarterly.
- How does compound interest work?
“Compound interest is when you earn interest on your interest,” says Chris Gaffney, President of World Markets at TIAA Bank in St Louis. When you reinvest your 5% interest payment from your $100 investment, your next interest payment is based on $105. So instead of $5, you get $5.25. Reinvest that and you’ll get $5.51 next time. Such is the math behind the magic that allows you to turn $5 invested daily to $400,000, just 45 years from now. It’s also the reason why you should start investing early. “The sooner you start, the more compounding is likely to help your money grow,” he said.
- Is there a better time of year to start investing?
As soon as possible. Waiting for an opportune time to invest is akin to timing the market, which never works well in the long run. That said, “research show that there’s some seasonality” to stock market returns. For instance, summer and early fall are often volatile, which can “be an excellent time to invest by taking advantage of lower prices,” said Andrew Crowell, Vice Chairman of Wealth Management at D.A. Davidson & Co. Following Warren Buffett’s rule to be “fearful when others are greedy and greedy when others are fearful,” new investors could benefit from buying during summer and fall, he says.
- What percentage of my savings should I start investing with?
Invest everything except your emergency fund of three to six months’ living expenses. “It’s more important to start investing than get hung up on how much,” Crowell says. Even $50 could become more than $100,000 in 40 years. Ideally, you should aim for 10 – 15% of your income in your 20s, 20% of your income in your 30s and 30% and more on your 40s. As you gain more confidence, challenge yourself to invest more. If you get a raise, invest half of it. “Just be sure you’re not investing money that you think you’ll need in the next five years,” Schwab-Pomerantz said.
- How risky should I be with my investment?
“Investing shouldn’t be in the context of risk,” says Rick Edelman, Founder and Executive Chairman of Edelman Financial Services. It should be about achieving goals. When you get into a car, the first question isn’t, “How fast am I willing to drive?” That depends on your destination and how long you have to get there. Likewise, your investment goal and time frame determine how much risk you take. If your investment need to earn 8% per year to reach your goal, you need to be aggressively invested in stock, Edelman says. However, if you can reach your goal at 2% rate of return, you can be more conservative.
- What is an expense ratio and where does that money go?
An expense ratio is the annual fee charged to shareholders to cover fund costs, expressed as the percentage of fund assets that go towards costs instead of being invested. The majority of fees goes to management fees. This is why an active fund with a manager who spends a lot of time selecting investments has a higher expense ratio than a passive fund. Other expenses include administrative costs, taxes and accounting fees. It does not include trading costs incurred by the fund. “You should generally spend less than 0.5%,” the lower is better Edelman explains.
- What’s more important? The cost of the fund or past performance?
While past performance is important, costs are even more so. Investors often “overlook how much investment costs can add up over time,” Schwab-Pomerantz says. She illustrates this with an example: If at age 45 you invest $1 million in a fund costing 2% per year, by 85 you’ll have $4.8 million at a 6% return. If your total cost was only 1%, by 85 you’ll have about $7 million, $2.2 million more. Cost are one of the few things investors have control over. Past performance is no guarantee of future results, but you can be sure you’ll pay your share of fund expenses.
- What are emerging markets, and should I invest in them?
Emerging markets are “countries that have ‘emerging’ economies,” Gaffney says. There’s no definitive ‘criteria’ for size and growth rates, but the largest emerging economies are Brazil, Russia, India and China,” collectively called BRIC. Emerging markets typically have a financial infrastructure including a national currency, bank and a stock exchange but low to middle per capita income. Because they are still developing, EM investment can grow faster than investment in developed nations. But EM can be risky as political and currency instability can make investment volatile. While international exposure is an important part of a diversified portfolio, EM exposure should be taken with a grain of risk tolerance.
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