Time horizon. This is the length of time that your money will be invested, before you need to convert your investments back into cash to pay for your goals. The longer your time horizon, the more risk you can potentially take. Some goals, such as saving for a house down payment, have hard deadlines, with all money needed on a particular day. Other goals, like investing for retirement, involve softer deadlines, because you’ll spend the money saved over time.
Risk tolerance. The amount of investment risk you can reasonably take is partly driven by factors such as your time horizon and the degree of risk in the rest of your financial life. For instance, those with longer time horizons and more secure jobs can arguably take greater risk. But you also need to consider how much risk you can personally stomach, including how unnerving you find market volatility and how likely you are to sell in a panic if there’s a large market decline.
Loss aversion. While investors are often said to be risk averse, they’re more accurately described as loss averse—meaning they hate to lose money. In fact, when faced with a loss, investors may increase risk in an effort to avoid the loss. One example: Investors will often double down on a losing stock, hoping to recoup their loss more quickly.
Asset classes. The three major asset classes are stocks, bonds and cash investments. The latter includes savings accounts, certificates of deposit and money market funds. Alternative investments, such as real estate, gold stocks and hedge funds, are sometimes considered a fourth asset class. These various alternative investments, however, don’t have many financial characteristics in common, except the hope that they will perform well when financial markets are struggling.
Diversification. To reduce the risk of owning any particular asset class, investors will buy hundreds and sometimes thousands of individual securities. Suppose you own just one or two stocks. You will have a lot of so-called idiosyncratic risk, and there’s a danger that you won’t be rewarded for the risk you are taking. As you add more stocks to your portfolio, you reduce this idiosyncratic risk and increase the likelihood that your results will track the broad market’s performance.
Correlation. Investors often try to include uncorrelated investments in their portfolio, in the hope that some securities will post gains when others are struggling. The correlation among different stocks is typically quite high. Instead, to lower the volatility of a portfolio with significant stock exposure, investors will often turn to bonds, cash investments and alternative investments.
Volatility and investment compounding. The more volatile a portfolio’s performance, the less efficient the process of compounding will be. Consider an example. Portfolio A gains 10% both this year and next. Portfolio B gains 20% in the first year and 0% in the second year. Portfolio C gains 25% in the first year and loses 5% in the second. At first glance, you might imagine the three portfolios will have the same cumulative return. But in fact, the cumulative gain would be 21% for portfolio A, 20% for portfolio B and just under 19% for portfolio C. For further information, check out the chapter on investment math.
Rebalancing. Investors often set target percentages for their various holdings, such as the amount they want to keep in bonds, real estate investment trusts, U.S. large-company stocks and so on. Once you’ve settled on such targets, you might periodically rebalance back to these target percentages, which will involve lightening up on recent winners and adding to lagging sectors. Rebalancing is mostly about controlling a portfolio’s risk level, though it may also boost returns, especially when rebalancing among various stock market sectors.
Mutual funds vs. exchange-traded funds. Owners of mutual funds can trade shares through a brokerage firm or deal directly with the fund company involved. Either way, the ultimate buyer or seller is the mutual fund itself, with the share price established as of that day’s market close. By contrast, exchange-traded funds are listed on the stock market, just like any other stock, and shares can be bought from and sold to other investors throughout the trading day.
Load vs. no-load funds. Load funds are sold through brokers and might charge a commission when you buy or a commission when you sell. These funds might also charge an ongoing commission, known as a 12b-1 fee. By contrast, a no-load fund won’t charge a front-end or back-end commission, and any 12b-1 fee should be modest.
Expense ratio. This is a fund’s annual expenses expressed as a percentage of fund assets. A fund that levies a 0.5% expense ratio is costing you 50 cents a year for every $100 invested.
Fees vs. commissions. Brokers are compensated by charging commissions when you buy and sell. Meanwhile, financial advisors charge fees. While a small number of financial advisors levy hourly fees or annual retainers, most charge a percentage of a client’s portfolio value, such as 1% a year. In addition to this 1% for financial advice, investors will also incur the expenses charged by the mutual funds, annuities and other investment products that they buy.
Conflicts of interest. Different advisor compensation arrangements create different conflicts of interest. Brokers who charge commissions have an incentive to get you to trade and to buy high-commission products. Advisors who charge a percentage of assets have an incentive to manage as much of your money as possible. To that end, they might push you to roll over 401(k) assets to an IRA, even though the 401(k) has great low-cost investment offerings, and they might dissuade you from using your portfolio to pay down debt.
Market efficiency. The markets are often described as efficient, though what’s meant by that phrase varies. Some academics think that stock and bond prices always accurately reflect all available information. Others argue that, while the markets aren’t always efficient, they are efficient enough that very few investors will manage to earn market-beating returns over the long haul.
Index vs. active funds. An actively managed fund aims to pick securities that will outperform the fund’s benchmark index, while an index fund buys many or all of the securities that make up a market index in an effort to match the index’s performance.
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