Deciding how to invest your savings is one of the most important decisions you will make. Fortunately, successful investing doesn’t need to be complicated. You can make good investment decisions if you understand a few simple concepts and have a financial plan. The two most important concepts investors need to understand are risk vs. reward and asset class diversification.
Risk vs Reward
Investment options range from “very safe” to “very risky”. Riskier investments usually offer the chance for higher returns over the long run. Riskier investments also have a greater possibility of loss. Academic research shows that the most effective way to invest is by blending assets of different risk levels. This process is called diversification and is a key part of building a high-quality investment portfolio.
The three major asset classes appropriate for most investors are stocks, bonds, and cash.
Cash is usually considered to be the safest option, along with debt obligations of the US Government, which are often referred to as “Treasuries”. Cash, and mutual funds that invest in cash equivalents like money market funds, have the lowest risk. These kinds of investments also provide lowest potential returns. Often the return on cash is not even enough to keep pace with inflation. Keeping too much cash in your investment portfolio can cause you to lose real purchasing power over time.
Investment grade municipal and corporate bonds have more risk but are still generally considered safe investments. Bonds represent the debt of a company. Bonds are also known as “fixed income” investments. When companies borrow money, they issue bonds. Investing in a bond is the same as loaning money to the company that issued the bond. Bond investors expect to earn interest on their investments, and to have the loan principal paid back at some point in the future. If the company that issued a bond has financial difficulties, they may be unable to make the promised principal and interest payments. This risk is called default risk or credit risk. Investing in a fixed income mutual fund instead of individual bonds can help protect against default risk. Bonds are usually less risky than stocks, but riskier than cash.
Stocks, often called “equities”, are riskier than bonds, but also offer the chance for higher returns over the long run. Stocks represent ownership of a company. When you own a stock, you own a small slice of that company. Some investors choose to buy individual stocks, while others buy mutual funds or exchange traded funds. When you invest in an equity fund, you own shares in the fund and the fund may own stocks. Stocks offer higher potential returns, but also come with more risk than investing in bonds or cash.
There are some kinds of financial instruments with much greater risk than stocks, such as derivatives, futures, and options. These high-risk instruments are not appropriate investments for the vast majority of individual investors.
Which Should You Choose?
The mix of stocks, bonds, and cash is also known as your “asset allocation”. A high-quality investment plan makes use of all three of these asset classes. The right asset allocation depends on factors such as your savings goals, your time horizon, and your risk tolerance. Your financial plan should incorporate all these factors. The right asset allocation is ultimately the one that best supports your financial plan and maximizes the probability of successfully achieving your financial goals.
Matthew A Treskovich | CPA/PFS, CITP, CMA, CFP®, AEP®, MBA, CLU, ChFC, FLMI
Chief Investment Officer