Investing 101 - Understanding The Basics
The world of investments is a dynamic and ever changing arena. However, one of the ways investors can maximizing their performance and create wealth is by understanding the underlying principles guiding investing in general. And to do this, you have to first understand what investing encompasses. While it may seem easy to buy a stock at low and sell at high, in reality, this process can be quite challenging.
This is because certain factors like emotions, psychology, and volatility in the stock market can cause people to take irrational decisions. However, we at Financial Education believe that the key to mastering the market lies in understanding the market from the basics. In this article, we shall understand what investing is all about, how to create an investment plan, and more such areas so that you can make better investment decisions.
What is investing?
Investing is a broad term and no particular definition can accurately capture every part of investing. You can consider investing as the process of procuring an asset that can generate income and appreciate in value in the future. What determines if an item or product is an investment is a motive behind its procurement. If the aim of purchasing the product is to generate additional income and not for immediate consumption, then it is defined as an investment.
Investment is therefore any product or asset that can help you generate wealth. These assets include stocks, bonds, mutual funds, and real estate property. When you buy a property to help produce goods that will in turn bring in more money, it is also an investment.
How to Create an Investment Plan?
Creating an investment plan requires a systematic approach. Though you may start without any written plan, having a laid-out plan will surely work to your advantage. But, you may be wondering how to create an efficient investment plan? Well, you can create an investment plan that suits your profile by applying the following steps:
- Define your investment goal: It is vital to have clearly defined goals before setting out on investing. Determine what you want to achieve through investing before making any investment, as this will help you manage your investment in a better manner. The purpose of your investments could be for wealth preservation or capital expansion, or it could be as simple as expanding your cash flow. So, define your investment goal beforehand to achieve the best possible results.
- Decide on the asset class you want to invest in: Once you have clearly defined your goals, deciding the asset class you want to invest in will help you achieve your goal. You can decide to go for dividend stock, ETFs, or even Index funds. There are several asset classes that an investor can choose from.
- Define your investment timeframe: How long would you want to hold your investment? Your investment time frame can be long, medium, or short-term. Determining your investment timeframe will also help you in deciding which asset class to invest in.
- Decide on the market you want to invest in: Decide if you want to focus on the domestic market or if you would prefer an international market. Even when you invest in companies that are listed locally, you may discover that those companies oftentimes have ties with various foreign companies. So, deciding which market you want to invest in is a great way to achieve clarity while investing your capital.
- Determine your risk tolerance level: Analyzing your risk tolerance level will help you determine the individual holdings for your portfolio. You need to diversify your holdings to minimize your risk and achieve a well-balanced portfolio that can adjust according to market volatility.
- Determine the criteria for investments: This is especially applicable in a situation where you are investing in stocks. Some of the criteria to look at include dividend growth, profitability ratios, earnings growth, company profitability & management, overall market sentiment, and more such factors. Determining these factors and studying them beforehand will help you make better investment decisions.
- Decide on how to sell your investment: Determine the time or price level you want to sell your investment in order to maximize the returns. Put into consideration the target price and the return on capital you have generated. Pre-determining an exit price or having a fixed return percentage will help you exit your investments efficiently.
- Decide on asset class weightage: There are different ways to weigh assets. Some of the ways include income, the current value of the assets, or the cost basis. You may not have to bother about asset weighting if you are just starting out. But as you get closer to retirement, you must do proper portfolio diversification in order to minimize risk and create a well-balanced and well-diversified portfolio.
- Allocate time for rebalancing your assets: Have a fixed date where you go through your portfolio and determine if you are still on track. Re-balancing your portfolio is a great way to minimize the impact of market volatility on your investments. While you are at it, also set aside a percentage of your portfolio for testing the waters. The percentage you set aside for this purpose is an amount you will be willing to lose if it comes to that.
Compounding and Wealth Creation
Compounding has been referred to by many as the secret to wealth creation. Compounding interest is the principle of earning more not just in the invested capital but in the form of interest. The magic of compounding is that the interest of investment also earns interest. In this situation, your money not only grows but also the amount you earn from your investment keeps increasing with time.
To maximize compounding interest, you need to understand the principle of exponential growth and its impact on the value of money. With compound interest, investors can optimize their money and create wealth faster. The strength of compound interest lies in this ability to earn interest on a sum that was previously earned as interest. This continuous cycle of earning interest on already earned interest is what leads to an exponential growth in wealth.
Benefits of investing
Investing is a great way to beat inflation, create wealth for your future, achieve financial freedom, and more. The founder of Financial Education, Jeremy Lefebvre, believes that every individual should invest whatever they can in the financial markets to help them achieve their financial goals efficiently. So, let’s go over some of the benefits of investing.
- Beats inflation: Investing unlike savings keeps you one step ahead of inflation. Money in the bank after a few years will reduce in value. However, when you invest, your money grows in value and you can stay ahead when the purchasing power of money reduces.
- Helps to build wealth: Investing is one of the most efficient ways to build wealth in the long term. Saving alone is not enough. The primary reason for saving should be to invest. If your goal is to accumulate wealth, then you need to decide on investment vehicles that align with your goals and maximize them. Investing is indeed the pathway to creating huge wealth.
- Helps you to achieve your retirement goals: It is the desire of everyone to retire in comfort. However, to achieve that, you need to put your money to work through investing. Dumping your money in a savings account will end up earning you a few extra dollars after so many years. However, the more you invest, the more you can maximize compounding interest and retire in comfort.
- Lower tax payment: Through investments, you can lower the amount you remit to the tax office. For instance, your 401k investments are only taxed when you withdraw them in your retirement. This goes a long way to help you save money in the long run.
- Helps in meeting financial goals: You can invest to meet specific long-term financial goals. For instance, if you want to buy a house in 10 years, it would make sense to invest your money to meet that goal faster rather than keeping it in your savings account.
The benefits that come with investing are numerous and are a sure way to arrive at your desired financial destination.
Assets Classes in the Financial Markets
Different asset classes are available in the financial market. An asset class is a group of financial instruments which have similar financial characteristics and behave similarly in the marketplace. These investments are normally subject to the same rules and can be traded together in the same markets. Some of the popular asset classes in the financial markets are as follows.
Stocks are the shares of publicly traded companies issued to the general public. These equities are traded on stock exchanges across the globe. An investor can make a profit from stocks by either receiving dividends intermittently or selling off the shares when the value rises.
Bonds are debt securities issued by the government or corporations as a means of raising money for capital projects. These debt securities pay a specified rate of return to the bondholders as compensation for releasing their money. Bonds are low-risk investments when placed side by side with stocks and other securities.
3. Mutual Funds
Mutual funds are a type of investment that involves the pooling of resources of several investors together to invest in securities. These funds are placed in the care of portfolio managers who allocate the capital in various securities according to their research and analysis. The benefit of mutual funds over other investment vehicles is that it enables investors to diversify their investments and spread their funds across several sectors in order to achieve a well-balanced portfolio.
4. Exchange-Traded Funds
Exchange-Traded Funds are a popular investment vehicle. Though ETFs have basic similarities with mutual funds, they are not the same. ETFs are traded on stock exchanges and are affected by the market movement caused by prevailing economic conditions. What this means is that the value of ETFs can change in a matter of hours. ETFs can also be bought or sold in a single trading day. However, with several types of ETFs available to investors that offer lower expense ratios when compared to mutual funds, the popularity of ETFs has been on the rise.
Investment strategies for different asset classes
There are several factors to look at while considering the best investment strategy to apply for different asset classes. The strategy you adopt may depend on your income, the value of the investments, as well as the growth rate of such investments. Below are some of the strategies that are used in establishing the allocation of assets.
1. Strategic Allocation of Assets
Through this method, an investor may invest in a combination of different assets based on the expected date of returns. While at it, investors also take into consideration the risk tolerance rate as well as the timeframe for the maturation of the investment. Strategic asset allocation employs diversification as a tool for minimizing risks and increasing returns on investment.
2. Dynamic Allocation of Assets
This type of strategy combines different assets based on the investor’s investment history as changes occur in the market. The buying and selling of assets are tied to the rate of appreciation and depreciation over time. Investors actively sell those assets that fall in value and buy the ones that appreciate over time. This is done to ensure that there is a steady increase in overall returns on investment.
3. Integrated Allocation of Assets
In allocating assets using this strategy, the investor first analyses his expectations as well as the level of risk tolerance before deciding on the assets to combine. This allows proper allocation of capital and helps in building a well-diversified and well-balanced portfolio via integrated allocation of assets.
There are numerous ways to invest and accumulate wealth. However, there is a need to understand the different methods and strategies that investors can apply in their investments to get the most out of them. Having a good understanding of various asset classes is not enough. Investors need to understand the different strategies of asset allocation available to them and how to use them to make the most of their investment.
Running a diversified portfolio will not only help you to minimize risk but also to maximize returns and make up for any shortfall in any particular asset. However, before making any investment decision, always check the current market conditions and other factors that might affect the value of an asset class, as investments in the financial market are subject to market risk. If you liked this article, make sure to visit Jeremy Lefebvre’s YouTube channel “Financial Education” for more such informative content! Happy investing!