Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you’ll see that the most important foundation on which to base your investment education is simply good common sense.
Don’t be intimidated by jargon.
Don’t worry if you can’t understand the experts in the financial media right away. Much of what they say is jargon and is actually less complicated than it sounds. Don’t hesitate to ask questions; when it comes to your money, the only dumb question is the one you don’t ask. Don’t wait to invest until you feel you know everything. You will never know and understand everything. The financial markets are complex and constantly changing. If you wait to invest until you “know everything” you may miss out on maxing your IRA or taking advantage of an opportunity.
IRAs hold investments – they aren’t investments themselves.
Let’s address a source of confusion that immediately throws many new investors off. If you have an Individual Retirement Account (IRA), a 401(k), or other retirement plan at work, you should recognize the difference between that account or plan, and the actual investments you own within that account or plan. Your IRA or 401(k) is really just a container that holds investments and has special tax advantages. Some investments are best held in a tax-advantaged account; other may be more appropriate for a taxable account. Think of this IRA as a container that can hold various investments such as stocks, bonds, ETF’s, etc. You can be as aggressive or conservative as you want with this account.
Understand stocks and bonds.
If you buy stock in a company, you are literally buying a share of the company’s earnings. You become an owner, or shareholder, of the company. If you buy bonds, you’re lending money to the company (or government body) that issued the bonds. You become a creditor, not an owner, of the bond issuer.
Don’t put all your eggs in one basket.
Consider including several different types of investments in your portfolio. Examples of investment types include stocks, bonds, commodities, art, and precious metals. Cash also is considered an asset class, and includes not only currency, but cash alternatives such as money market instruments. Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time.
Recognize the tradeoff between an investment’s risk and return.
There is a direct relationship between investment risk and return; the lowest-risk investments typically offer the lowest return at any given time. The highest-risk investments will generally offer the chance for the highest returns. A higher return is your potential reward for taking greater risk.
Understand the power of compounding on your investment return.
Compounding occurs when you “let your money ride.” When you reinvest your investment returns, you begin to earn a “return on the return.”