Knowing the fundamentals of investing and how to improve your financial well-being by investing is one of the most important things you’ll need to do—and you don’t have to be a genius to do it. You just need to know a few basics, form a plan, track the results, and be prepared to make adjustments along the way.
Long term, stocks have historically outperformed all other investments.
Stocks have historically provided the highest returns of any asset class—close to 10% over the long term. The next best performing asset class is bonds. Long-term U.S. Treasury’s have returned an average of more than 5%.
Short term, stocks can be hazardous to your financial health.
On Dec. 12, 1914, stocks experienced the worst one-day drop in stock market history—24.4%. On Oct. 19, 1987, the stock market lost 22.6%. More recently, the shocks have been more prolonged and painful: If you had invested in a NASDAQ index fund around the time of the market’s peak in March 2000 you would have lost three-fourths of your money over the next three years. And in 2009, stocks overall lost a whopping 37%!
Risky investments generally pay more than safe ones (except when they fail).
Investors demand a higher rate of return for taking greater risks. That’s one reason that stocks, which are perceived as riskier than bonds, tend to return more. It also explains why long-term bonds pay more than short-term bonds. The longer investors have to wait for their final payoff on the bond, the greater the chance that something will intervene to erode the investment’s value.
The biggest single determiner of stock prices is earnings.
Over the short term, stock prices fluctuate based on everything from interest rates to investor sentiment to the weather. But over the long term, what matters are earnings.
Rising interest rates are bad for bonds.
When interest rates go up, bond prices fall. Why? Because bond buyers won’t pay as much for an existing bond with a fixed interest rate of, say, 5% because they know that the fixed interest on a new bond will pay more because rates in general have gone up.
Conversely, when interest rates fall, bond prices go up in lockstep fashion. And the effect is strongest on bonds with the longest term, or time, to maturity. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most when rates fall.
Inflation may be the biggest threat to your long-term investments.
While a stock market crash can knock the stuffing out of your stock investments, the market has always bounced back and eventually gone on to new heights. However, inflation, which has historically stripped 3.2% a year off the value of your money, rarely gives back what it takes away, so plan accordingly.
U.S. Treasury bonds are as close to a sure thing as an investor can get.
The conventional wisdom is that the U.S. government is unlikely ever to default on its bonds—partly because the American economy has historically been fairly strong and partly because the government can always print more money to pay them off if need be. As a result, the interest rate of Treasurys is considered a risk-free rate although your return will suffer if interest rates rise, just like all other bonds.
A diversified portfolio is less risky than one that has one or few investments.
Diversifying—that is, spreading your money among a number of different types of investments—lessens your risk because even if some of your holdings go down, others may go up (or at least not go down as much). On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin.
Reap the Rewards of Good Planning
At the end of the day, there is no guarantee that you’ll make money from the investments you make. But if you get the facts about saving and investing and follow through with an intelligent plan, you should be able to gain financial security over the years and enjoy the benefits that come from managing your money and investments responsibly.