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Choosing The Right Investments
By John M. Gannon
Winter 2008-09
Like every investor, you want to choose investments that will provide the growth and income you need to meet your financial goals. To do so, it is important to understand your investment choices and how different types of investments put your money to work.
It is equally important to understand yourself as an investor. A portfolio that is right for someone else may not be best for you. The factors that make a difference are:
- your age
- your goals, or what you want to accomplish by investing
- the timeframes for your various goals
- your attitude toward risk, i.e. your risk tolerance
Once you have devised a strategy for choosing investments appropriate to each of your goals, you have taken a major step toward meeting them.
General Rules of Investing
As a general rule, the younger you are and the more time you have to reach a financial goal, the more investment risk you can afford to take.
On the other hand, when you are in your late 50s or 60s, you probably will want to exercise more caution about taking on investment risk, since your portfolio may not have a chance to recover from a market downturn before you need to start drawing on your retirement assets. When you retire, your goal is not only providing continued growth while taking limited investment risk but also ensuring that you have a stream of income that can cover a portion of your living expenses.
But these are just guidelines. No single approach to choosing investments will work for everyone or will be right for every situation. You will want to tailor your strategy to your own unique needs and circumstances.
What does make sense for all investors is concentrating on investments that, however different they are from each other, share these important characteristics:
- The investments are easy to evaluate because there’s lots of information about them. Regulators require disclosure of certain information to investors through documents such as mutual fund prospectuses, corporate filings for stock issued by public companies that trade on the major stock markets, and prospectuses or offering statements for bonds.
- The investments are easy to buy and sell, either through a brokerage account or in some cases directly from the issuer. Thinly-traded stocks or securities that are not listed on a major exchange are rarely a good idea for most investors.
- Sales charges for buying and selling the investments are clearly explained, as are any fees for selling within a certain timeframe.
- The investments are registered with the SEC or your state’s securities regulator, and the salespeople who sell them are licensed by FINRA.
- You understand the risks of the investment and how it works.
Investing for Short-Term Goals
Because you plan to spend the money you set aside for short-term goals relatively quickly, you will want to focus on safety and liquidity rather than growth in your short-term portfolio. Insured bank or credit union accounts as well as Treasury bills backed by the government’s promise to repay generally are considered safe investments.
Liquid investments are those you can sell easily with little or no loss of value, such as Treasury bills, money market accounts and funds, and other low-risk investments that pay interest. If those investments have maturity dates, as T-bills do, the terms are very short.
For example, say you are saving for a downpayment on a house that you hope to buy in about a year. If you have invested the money in stock funds and your portfolio fell sharply just as you were about to start your home search, you might need to postpone your plans to buy, or choose a less expensive home. On the other hand, if you had given yourself a little more time to accumulate the funds for a downpayment and invested them in liquid cash investments or insured bank products such as certificates of deposit (CDs), you could be more confident that the money you need would be available when you were ready to make an offer.
Investing for Medium-Term Goals
Choosing the right investments for mid-term goals can prove more complex than choosing them for short- or long-term goals. That’s because you need to strike an effective balance between protecting the assets you have worked hard to accumulate while achieving the growth that can help you build your assets and offset inflation.
Consider these possible strategies for managing a portfolio of investments for goals that are three to 10 years in the future:
- Balance your mid-term portfolio with a mix of high-quality fixed-income investments – such as a mid-term government bond fund or high-yield CD – with modest-growth investments, such as a diversified large-company stock fund. Then monitor the stock investments closely and be prepared to sell to limit your losses in the event of a major market downturn.
- If your goal is just three or four years away, you might limit your stocks to less than 30 percent of your portfolio. If your goal is eight or nine years in the future, you might invest 60 percent or more in a stock fund. It partly depends on your tolerance for risk. As your goal draws nearer, you can sell some of your stock fund shares and reinvest the assets in cash equivalents, such as CDs set to mature when you need the money, or a money market account or fund.
- Establish limits for gains and losses in your mid-term stock portfolio. For instance, you may decide ahead of time that you will sell an investment if it increases in value 20 percent or decreases 15 percent – or whatever percentage you find comfortable. As your goal approaches, you can reinvest your assets in less volatile investments.
Balanced funds, which usually invest in a mix of about 60 percent stocks to 40 percent bonds, growth-and-income funds, or equity income funds that invest in well-established companies that pay high dividends, might be appropriate choices for a mid-term portfolio. Ultimately, the key to achieving modest growth while minimizing risk is to keep a close eye on performance and gradually shift to more stable, income-producing investments as the date of your goal approaches.
Investing for Long-Term Goals
The general rule is that the more time you have to reach a financial goal, the more investment risk you can afford to take. For many investors, that can mean allocating most of the principal you set aside for long-term goals to growth investments, such as individual stocks, stock mutual funds and stock exchange-traded funds (ETFs).
While past performance is no guarantee of future results, historical returns consistently show that a well-diversified stock portfolio can prove the most rewarding over the long term. It is true that over shorter periods – say, less than 10 years – investing heavily in stocks can lead to portfolio volatility and even to losses. But when you have 15 years or more to meet your goals, you have a good chance of being able to ride out market downturns and see short-term losses eventually offset by future gains.
Your Risk Tolerance
Both your age and your timeframe for meeting specific financial goals play a role in determining your risk tolerance. If you are young and have a long time to meet your goals, you may have a higher risk tolerance than someone nearing retirement and counting on investment income to live on for two or three decades.
Above all, you need to feel comfortable with the risk you take. If changes in the value of your portfolio keep you tossing and turning at night, or your instinct is to sell your investments every time the market drops, then you may want to consider shifting to a more moderate investment mix, with a greater emphasis on predictable, income-producing investments, such as bonds and bond funds.
Here’s the bottom line: At every stage of your investing life, the more carefully you plan and the more informed your investment decisions, the better your chances of meeting all your goals.
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John Gannon is Senior Vice President of FINRA, the world’s leading private-sector provider of financial regulatory services. Visit www.saveandinvest.org, a comprehensive website to help servicemembers manage their money with confidence.
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Tax-Deferred And Tax-Free Accounts
For long-term goals such as retirement or education for your children, you can give your portfolio a significant boost by taking full advantage of any available tax-deferred and tax-free investment accounts.
When you invest through a tax-deferred account, including the Thrift Savings Plan (TSP) and traditional individual retirement accounts (IRAs), you do not owe income tax until you begin making withdrawals from the account, presumably after you retire.
Because you do not have to pay taxes on your earnings every year, your investment compounds untaxed, significantly enhancing its long-term growth potential. In some cases, you can defer taxes on your contributions to these accounts as well, helping your account to compound even faster.
