Fundamental Concepts of Successful Investing
Most of you may have already read this from A G Edwards online. Definitely worth a reread:
Fundamental Concepts of Successful Investing. Before you begin investing, it's helpful to understand some of the factors that will affect your investment decisions, such as:
Risk and Volatility
Liquidity
Time Horizon
Total Return
Diversification
Tax Consequences
Dollar Cost Averaging
The Value of Time
Once you understand these factors, you'll need to assess your current financial situation and develop your investment goals.
Risk and Volatility When most people think of risk in their investment portfolios, they think of price fluctuations in the open market (also known as volatility or market risk). However, many investors don't realize that even "safe" investments can be affected by the risk of inflation eroding purchasing power. With that in mind, you should be aware of the other types of risk you may encounter with different investments.
Inflationary risk, also known as purchasing power risk, is the decline in the purchasing power of dollars over time, so that even the "safest" investments can leave investors with substantially less purchasing power. For example, assuming an inflation rate of 4% for the next 10 years, if you have a $100 today, 10 years from now inflation will have eroded that $100 so that it is worth only $68.
Investment or credit risk is the possibility that a company backing a security will not be sufficiently profitable to remain in business.
Interest rate risk is the fluctuation in the prices of some investments, such as bonds, due to changes in prevailing interest rates. When interest rates rise, new issues of bonds come to market with higher yields than older securities, making those older bonds worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding bonds worth more. Hence, their prices go up. As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
When considering your own risk tolerance, you should understand that investments associated with higher risk typically offer higher reward potential over time. A key factor to successful investing is to identify how much risk you are willing to assume in exchange for potential investment gains.
Liquidity A "liquid" investment is one that can be readily turned into cash if you need the funds on short notice. Investments can vary greatly in their degrees of liquidity. Money market funds and savings accounts are very liquid; so are investments with short maturity dates such as CDs. But if you're investing in such accounts as an IRA, employer's retirement plan or custodial account for longer-term goals, liquidity is not an issue.
Time Horizon Different investors have different time frames in which to achieve their investment objectives. Generally, young investors with long time horizons should be able to assume greater risks because they have more time to offset any losses with the higher return potential of investments with greater risk. Older investors, however, often choose to reduce risk because they have less time to recoup losses.
Total Return All investments provide one or a combination of two different types of returns to investors: income or growth. Income is the interest or dividends earned from money market funds, CDs, bonds and certain stocks. Growth is the price appreciation of a security. The total return of an investment is the combination of income and growth realized over a given time period.
In selecting investments based upon their expected total return, you should understand which portion is generated from income and which from growth. Usually, the greater the reliance on income, the lower the market risk but the greater the long-term purchasing power (or inflationary) risk.
Diversification Building a diversified portfolio with securities spread across different investment classes can help you avoid the risk of having all of your eggs in one basket. By mixing industries and types of assets, you spread your risk. A particular market condition may have less impact if your portfolio consists of a wide assortment of securities than if you purchase only one type of security.
Most beginning investors don't have sufficient capital to properly diversify by purchasing individual securities. Investing in mutual funds allows you to buy a professionally managed, diversified portfolio with relatively small dollar amounts.
In addition, many mutual funds allow you to take advantage of dollar cost averaging by investing at regular intervals.
Mutual fund investing involves risk. Your principal and investment return in a mutual fund will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.
Tax Consequences Not all investment returns are subject to the same taxation. The dividends you earn on stocks and any capital gain, or profit, you have when you sell are taxable in the year you collect them. Your dividends are taxed as ordinary income, but long-term capital gains are taxed at a maximum federal rate of 20%. (A gain is considered long term if you owned the investment for more than a year.) Short-term capital gains are taxed at your ordinary tax rate.
You're not taxed on any unrealized gain, or increase in the value of your investment while you still own it. Some tax-advantaged investments (such as most municipal bonds) offer federal- (and possibly state-) tax-free interest. Some municipal bonds may be subject to the alternative minimum tax. There are also vehicles (such as IRAs and annuities) that provide tax-deferred or even potentially tax-free growth, enabling you to postpone taxation until you access your funds.
Mutual fund dividends and profits on mutual fund distributions are taxable (unless held in a qualified retirement account), but no tax is due on the increased value of a fund until you sell it. The capital gains incurred by the fund when it sells shares of stock in the fund are passed through to you annually regardless of whether you sell your mutual fund shares.
Dollar Cost Averaging Dollar cost averaging, the practice of committing a fixed amount of money to an investment program on a regular basis, is a popular practice with many long-term investors. By investing a set amount regularly (usually monthly or quarterly), investors are able to avoid the pitfalls of trying to time market peaks and valleys. Also, because the dollar amount of the investments is set, investors who practice dollar cost averaging buy more shares of a stock or mutual fund when they are less costly and fewer shares when they are more expensive. Like any investment strategy, dollar cost averaging doesn't guarantee a profit or protect against loss in a declining market. Because dollar cost averaging requires continuous investment regardless of fluctuating prices, you should consider your financial and emotional ability to continue the program through both rising and declining markets.
Value of Time The design of your portfolio should take advantage of time and conform to your personal objectives and risk tolerance. The earlier you begin to invest, the longer you can benefit from tax-deferred compounding in certain investments. With tax-deferred vehicles, you don't pay taxes on your returns until you begin making withdrawals, usually at retirement. However, withdrawals before age 59 1/2 are subject to a 10% IRS penalty (certain exceptions apply).
To understand the importance of tax deferral, compare the growth of a $10,000 investment in a tax-deferred account with the growth of the same amount in a taxable account. Assuming an 8% return and a 28% federal income tax rate, after 30 years you would have accumulated a nest egg of $100,627 in a tax-deferred account, compared with $53,659 in a taxable account. Even if you take out your entire investment in one lump sum and pay taxes on that amount, you will receive $75,251. This example is for illustrative purposes only and does not reflect the return on any particular investment.
Email me that you have read the above post.
Fundamental Concepts of Successful Investing. Before you begin investing, it's helpful to understand some of the factors that will affect your investment decisions, such as:
Risk and Volatility
Liquidity
Time Horizon
Total Return
Diversification
Tax Consequences
Dollar Cost Averaging
The Value of Time
Once you understand these factors, you'll need to assess your current financial situation and develop your investment goals.
Risk and Volatility When most people think of risk in their investment portfolios, they think of price fluctuations in the open market (also known as volatility or market risk). However, many investors don't realize that even "safe" investments can be affected by the risk of inflation eroding purchasing power. With that in mind, you should be aware of the other types of risk you may encounter with different investments.
Inflationary risk, also known as purchasing power risk, is the decline in the purchasing power of dollars over time, so that even the "safest" investments can leave investors with substantially less purchasing power. For example, assuming an inflation rate of 4% for the next 10 years, if you have a $100 today, 10 years from now inflation will have eroded that $100 so that it is worth only $68.
Investment or credit risk is the possibility that a company backing a security will not be sufficiently profitable to remain in business.
Interest rate risk is the fluctuation in the prices of some investments, such as bonds, due to changes in prevailing interest rates. When interest rates rise, new issues of bonds come to market with higher yields than older securities, making those older bonds worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding bonds worth more. Hence, their prices go up. As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
When considering your own risk tolerance, you should understand that investments associated with higher risk typically offer higher reward potential over time. A key factor to successful investing is to identify how much risk you are willing to assume in exchange for potential investment gains.
Liquidity A "liquid" investment is one that can be readily turned into cash if you need the funds on short notice. Investments can vary greatly in their degrees of liquidity. Money market funds and savings accounts are very liquid; so are investments with short maturity dates such as CDs. But if you're investing in such accounts as an IRA, employer's retirement plan or custodial account for longer-term goals, liquidity is not an issue.
Time Horizon Different investors have different time frames in which to achieve their investment objectives. Generally, young investors with long time horizons should be able to assume greater risks because they have more time to offset any losses with the higher return potential of investments with greater risk. Older investors, however, often choose to reduce risk because they have less time to recoup losses.
Total Return All investments provide one or a combination of two different types of returns to investors: income or growth. Income is the interest or dividends earned from money market funds, CDs, bonds and certain stocks. Growth is the price appreciation of a security. The total return of an investment is the combination of income and growth realized over a given time period.
In selecting investments based upon their expected total return, you should understand which portion is generated from income and which from growth. Usually, the greater the reliance on income, the lower the market risk but the greater the long-term purchasing power (or inflationary) risk.
Diversification Building a diversified portfolio with securities spread across different investment classes can help you avoid the risk of having all of your eggs in one basket. By mixing industries and types of assets, you spread your risk. A particular market condition may have less impact if your portfolio consists of a wide assortment of securities than if you purchase only one type of security.
Most beginning investors don't have sufficient capital to properly diversify by purchasing individual securities. Investing in mutual funds allows you to buy a professionally managed, diversified portfolio with relatively small dollar amounts.
In addition, many mutual funds allow you to take advantage of dollar cost averaging by investing at regular intervals.
Mutual fund investing involves risk. Your principal and investment return in a mutual fund will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.
Tax Consequences Not all investment returns are subject to the same taxation. The dividends you earn on stocks and any capital gain, or profit, you have when you sell are taxable in the year you collect them. Your dividends are taxed as ordinary income, but long-term capital gains are taxed at a maximum federal rate of 20%. (A gain is considered long term if you owned the investment for more than a year.) Short-term capital gains are taxed at your ordinary tax rate.
You're not taxed on any unrealized gain, or increase in the value of your investment while you still own it. Some tax-advantaged investments (such as most municipal bonds) offer federal- (and possibly state-) tax-free interest. Some municipal bonds may be subject to the alternative minimum tax. There are also vehicles (such as IRAs and annuities) that provide tax-deferred or even potentially tax-free growth, enabling you to postpone taxation until you access your funds.
Mutual fund dividends and profits on mutual fund distributions are taxable (unless held in a qualified retirement account), but no tax is due on the increased value of a fund until you sell it. The capital gains incurred by the fund when it sells shares of stock in the fund are passed through to you annually regardless of whether you sell your mutual fund shares.
Dollar Cost Averaging Dollar cost averaging, the practice of committing a fixed amount of money to an investment program on a regular basis, is a popular practice with many long-term investors. By investing a set amount regularly (usually monthly or quarterly), investors are able to avoid the pitfalls of trying to time market peaks and valleys. Also, because the dollar amount of the investments is set, investors who practice dollar cost averaging buy more shares of a stock or mutual fund when they are less costly and fewer shares when they are more expensive. Like any investment strategy, dollar cost averaging doesn't guarantee a profit or protect against loss in a declining market. Because dollar cost averaging requires continuous investment regardless of fluctuating prices, you should consider your financial and emotional ability to continue the program through both rising and declining markets.
Value of Time The design of your portfolio should take advantage of time and conform to your personal objectives and risk tolerance. The earlier you begin to invest, the longer you can benefit from tax-deferred compounding in certain investments. With tax-deferred vehicles, you don't pay taxes on your returns until you begin making withdrawals, usually at retirement. However, withdrawals before age 59 1/2 are subject to a 10% IRS penalty (certain exceptions apply).
To understand the importance of tax deferral, compare the growth of a $10,000 investment in a tax-deferred account with the growth of the same amount in a taxable account. Assuming an 8% return and a 28% federal income tax rate, after 30 years you would have accumulated a nest egg of $100,627 in a tax-deferred account, compared with $53,659 in a taxable account. Even if you take out your entire investment in one lump sum and pay taxes on that amount, you will receive $75,251. This example is for illustrative purposes only and does not reflect the return on any particular investment.
Email me that you have read the above post.
posted by MoneyProf at Thursday, June 02, 2005
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