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If your goal is saving to buy a house next year, putting your down-payment in the stock market could be a disaster. Sure, you could gain 10-20% in a year, but you could also lose that much.
On the other hand, never investing in the stock market could mean you fall far short of what you need for retirement.
How do you make sense of investing? This post is here to help.
Never invest emergency savings in the stock market. Suze Orman
1 – Match risks to your time horizon
When you put part of your pay into a 401(k) plan at your company, you are investing. And when you save money to buy a house, you are investing.
Different investments have different risks. If your goal is saving to buy a house next year, putting your down-payment in the stock market could be a disaster.
The risk does not match the horizon. If the stock market is volatile, it goes up and down. If you can stay invested long enough, the ups outweigh the downs.
So, when you have a short-term horizon, less than three years, you need investments that have little or no risk to principle.
On the other hand, if your goal is saving for retirement, leaving your money in a savings account will be a disaster. Sure, your principle is safe. But, you took no risk, so the funds did not grow much.
When you can wait at least 5 to ten years, then investing in the stock market is preferable because well-diversified investments tend to go up over time.
2 – Diversify investment types
Buying one stock could give you huge returns, or lead to a complete loss.
Diversifying means allocating your investments to different categories: stocks, bonds, real estate, raw materials, etc. These categories respond differently to economic events, so an investment that goes down can be offset by one that goes up. You allocate portions of your investment among investment categories to reduce your overall risk. That helps protect your against a major loss on any single investment.
You will also want to diversify within categories. For stocks, you look at value and growth investment styles, large, mid and small-cap companies, and US stocks and international stocks.
Okay, now we are making it sound complex. You may want to get advice, either from a financial planner, broker or good robo-planner who can help create and asset allocation suitable for your goals.
3 – Allocate and then rebalance periodically
Once you diversify, you need to review the allocation among investments at least annually. Otherwise, the allocation could get way off track.
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Check to make your mix of investment by category still fits your goal. If your allocation is off, rebalance it by selling the excess of investments that performed well and buying the investments that have been underperforming. Good investments may lag at times, so rebalancing helps you to maintain the proper allocation to stay on track.
4 - Dollar-cost average – sometimes
Worried that the market is too high, that stocks could tumble? Emotions such as fear, as well as excitement or greed can lead to bad investment decisions.
One way to address fear of a correction is to dollar-cost average. This means adding new funds to your investment allocation by investing the same amount of money on a regular basis, e.g. once a month for six months.
5 - Keep costs down
What about costs? You generally want to avoid loads and other forms of broker commissions whenever possible. And you want to select investments that have low fees.