Starting to invest can be one of the most intimidating tasks you'll ever take on, but it can also be one of the most lucrative. Liberating yourself from the financial strain of paycheck-to-paycheck living and building yourself an investment portfolio that lets you look forward to an even brighter future is your best defense against the financial struggles that millions of Americans face.
In our final installment, we want to leave you with a few tips from some highly experienced professionals to guide you throughout your investing career.
Tip 1: You Don't Have to Pick Stocks to Win at Investing.
One reason why so many investors get hung up in getting started investing is that they don't have the time or inclination to comb through thousands of stocks and other investments seeking out the best ones. Here's some welcome news if that describes your current situation: you don't have to be a stock-picker in order to succeed with your investing.
For decades, researchers have known that the most important decision investors make is not which particular stocks of funds they buy, but how they divide their money across major investment categories.
In short, diversify well and you'll do well.
A landmark study in the 1980s concluded that when you looked at the quarterly returns of nearly 100 corporate pension funds, 93 percent of the variability in those returns came from differences in the way the funds broadly allocated their money across asset classes.
Subsequent studies have produced slightly different figures, but the overall lesson is clear: although spending time seeking out the best investments within a particular category can earn you extra returns, relying on well-diversified investment vehicles like mutual funds and exchange-traded funds will get you most of the way there.
Tip 2: Pay Attention to True Value.
Superstar investor Warren Buffett has said often that you can't rely on the stock market to tell you what a stock is actually worth. Rather, a stock has value as a money-making business, and fundamentals like profitability and growth provide help in figuring out what that true value is.
Of course, the real challenge is trying to figure out exactly what a stock's true value is. Entire books have been written on valuation, but some simple rules to keep in mind include the following:
Even great companies can be lousy investments if you buy them at the wrong time. Big tech companies have made billions in profits since 2000, but many of them have share prices that are still below where they traded at the top of the tech boom. The same goes for banking stocks at the height of the housing bubble.
Out-of-favor stocks, on the other hand, often offer the best bargains. You have to be careful to avoid weak companies that actually deserve their low share prices, but stocks that are simply in the depressed part of a regular business cycle often make smart buys.
Don't try to guess exactly when a stock will hit rock-bottom. If a stock's long-term prospects are sound, then whether you buy at the low or 5 percent above the low won't make much difference in your long-term returns.
Tip 3: Let Time Be Your Best Friend.
Finally, the biggest virtue an investor can have is patience. Over time, the magic of compound interest will make you rich, but only if you give it enough time.
Buffett is a good example of this phenomenon, as he earned 95 percent of the total value of his fortune after his 60th birthday.
The earlier you start investing, the easier it is to save up a nest egg that will provide for your financial needs for the rest of your life. Unfortunately, many investors don't even think about saving until they get closer to retirement, and by then, it's too late to take full advantage of the opportunities that investing offers.
That's why procrastination is your worst enemy, and why there's no better time than the present to get started with your investing today.
So Get Started, and Good Luck!
Thanks for reading our Investor Summer School series. We hope you've learned enough about investing to motivate you to get started with your own investment portfolio. Be sure to stay tuned to DailyFinance for ongoing guidance on how to invest better and take advantage of opportunities when they arise.
Financial Terms You Need to Know
Investing Summer School: 3 Indispensable Tips from the Pros
In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.
If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.
Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.
You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.
Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.
While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.
Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.
Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.
Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.
Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)
Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.
First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.
Read about the differences of supply and demand in the stock market and in our own lives here.
As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.
Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.
In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.
But the term also refers to an investment strategy -- one that can reduce risk through diversification.
Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.
Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.
The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.
But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.
First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.
Enter compound interest, which is far more exciting.
The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.
When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.
When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.
The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.
At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.