When faced with all the decisions that need to be made to ensure you select the proper investments to meet your long-term financial goals, it's easy to become overwhelmed.
How do you choose an optimal combination of investments to help you reach a goal that may be decades away?
The answer is to focus on the fundamentals. Make sure to get these basics right:
- Don't wait - invest now.
To put the power of compounding to work for you, start investing now. It's easy to put off investing, thinking you'll have more money or more time at some point in the future. Typically, however, you'll be better off saving less now than waiting and saving more later.
- Live below your means so you can invest more.
It's a basic fact that most people have trouble coming to grips with - the amount of money you have left over for investing is a direct result of your lifestyle. Don't have money for investing? Ruthlessly cut your living expenses. Redirect all those reductions to investments. This should help significantly with your retirement. First, you'll be saving significant sums for your retirement. Second, you're living on significantly less than you're earning, so you'll need less for retirement.
- Maintain reasonable return expectations.
When developing your financial goals, you'll typically decide how much you need, when you'll need the money, and how much you'll earn on those savings. Those factors will determine how much you need to save on an annual basis to reach your goals. The higher your expected return on your investments, the less you need to save every year. However, if your assumed rate of return is significantly higher than your actual rate of return, you won't reach your goals. Thus, it's important to come up with reasonable return expectations. While past returns aren't a guarantee of future returns, you'll want to start by reviewing historical rates of return for investments you're interested in. You can then adjust those returns based on your expectations for the future.
- Understand that risk can't be avoided.
All investments are subject to different types of risk, which can affect the investment's return. Cash is primarily affected by purchasing-power risk, or the risk that its purchasing power will decrease due to inflation. Bonds are subject to interest-rate risk, or the risk that interest rates will rise and cause the bond's value to decrease, and default risk, or the risk that the issuer will not repay the bond. Stocks are primarily subject to nonmarket risk, or the risk that events specific to a company or its industry will adversely affect a stock's price, and market risk, or the risk that a particular stock will be affected by overall stock market movements. These risks make some investments more suitable for longer investment periods and others more suitable for shorter investment periods.
- Diversify your portfolio.
When stocks had above-average returns for an extended period, diversification acted as a drag on total return. By definition, allocating anything other than all of your portfolio to the best-performing asset lowers your return. But when stocks declined substantially, the disadvantage of investing only in one asset class became apparent. Typically, you do not know which asset class will perform best on a year-to-year basis. Diversify your investment portfolio among a variety of investment categories. Also diversify within investment categories.
- Only invest in the stock market for the long term.
Stocks should only be considered by investors with an investment time frame of at least five years. Remaining in the market over the long term reduces the risk of receiving a lower return than you expected.
- Don't try to time the market.
Timing the market is a difficult strategy to accomplish successfully, since so many factors affect the market. Remember that most people, including professionals, have difficulty timing the market with any degree of accuracy. Instead, concentrate on setting up an investment program that works in all market environments and that you can stick with.
- Pay attention to taxes.
Ordinary income taxes on short-term capital gains and interest can go as high as 35%, while long-term capital gains and dividend income are taxed at rates not exceeding 15% (5% if you are in the 10% or 15% tax bracket). Using strategies that defer income for as long as possible can make a substantial difference in the ultimate size of your portfolio. Some strategies to consider include utilizing tax-deferred investment vehicles, minimizing portfolio turnover, selling investments with losses to offset gains, and placing assets generating ordinary income or that you want to trade frequently in your tax-deferred accounts.