Most people save and invest to achieve specific financial goals. Many people want to attend college and own their own home, for example, or you might want to travel widely, or accumulate enough money to start your own business.
The point is, to accomplish your goals you have to be clear about the answers to three key questions: What are your goals and what will they cost? When do you want to achieve each goal? How much risk can you tolerate?
Picking a Date
Part of setting investment goals is determining when you will need to use the money you’ve set aside. Most goals fit into one of three categories:
- Short term, usually within a year or two. The closer you get to your goal, the less risk you generally want to take with the money you’ve already accumulated to pay for it. This means you’ll be more inclined to put your money into federally insured bank accounts, which won’t lose value in six months or a year.
- Mid-term, usually within two to ten years. Mid-term goals are typically those for which you need time to accumulate the money. The more time you have, the more risk you can probably afford to take with your money. In such instances, you might want to invest some of your assets in stocks, either directly or through mutual funds, because of the potential for a higher return.
- Long term, usually more than ten years. Investing for longer-term goals generally means allocating a larger percentage of your money to stocks and mutual funds that invest in stocks. As you get closer to your goal, you can gradually shift a greater percentage of your accumulated account value into less risky investments.
Considering Risk and Return
Because virtually every investment carries some degree of risk, it is critical that you assess your tolerance for risk. If you are the sort of person who will lie awake at night worrying about your investments if you put most of your money in the stock market, then you might want to consider balancing your portfolio with lower-risk investments, such as highly rated bonds.
Should you decide to adopt a low-risk investing strategy, be aware that traditionally low-risk investments tend to have low rates of return. As a result, while you might be able to protect your principal from loss, you run the risk that your investment returns will not keep pace with inflation.
Historically, stocks have provided the best returns over the long-term, but their year-to-year fluctuations make them riskier than most bonds or cash.
Establishing an Emergency Fund
Emergencies happen. Your car breaks down. A pet you’re responsible for gets sick and requires expensive care. If something unexpected happens to you, will you have the money you need?
To keep yourself financially safe, especially in the face of unexpected events, you need to have an emergency fund. That’s an account that holds at least three to six months of your income.
If you don’t already have money in a savings account that you could use in an emergency, opening one should be your first investment decision. Then leave that money untouched unless you actually face a financial emergency.
Choosing Investments Wisely
After you’ve identified your goals and determined when you’ll need the money, it’s time to decide which combination of savings and investments is going to work for you. Once you’ve decided how much to allocate to stocks, bonds, and cash, there’s another important step you can take to minimize the risk of financial loss.
You might have heard the expression, “Don’t put all your eggs in one basket.” Diversification is the process of putting that advice into practice by purchasing different types of investments.
Diversification helps protect the value of your portfolio in the event that one or more of the investments you own performs poorly. For example, large-company and small-company stocks can behave quite differently under the same market conditions and expose you to different levels of risk. In some years, small-company stocks have risen significantly in value when stocks in the larger companies have dropped, and vice versa. So if you own both types of stock, a loss in one part of your portfolio can be balanced by a gain in another part.
You should be prepared to spend time learning about various investments and thinking about whether the investments you’re considering are appropriate at this point in your life. The more you know about your investment choices, the more likely you’ll make good decisions.
Remember, too, that you pay fees and expenses with virtually all financial products and services. Those costs reduce your returns. It’s important to find out what the costs are and compare them to alternatives.
Practicing Good Habits
Good habits pay off in many areas of life, and practicing good savings and investing habits is no exception. You should:
1. Take advantage of compound interest by saving regularly.
2. Pay any credit card balance on time and in full each month.
3. Budget a part of your income for saving and investing.
4. Always read your account statements for accuracy.
5. Never commit your money without fully investigating and understanding an investment.
6. Always understand and compare the costs involved in financial products and services.