What should you consider before investing? Investing is a relatively complex phenomenon, consisting of market conditions, economics, and your personal goals and financial situation, as well as your stage of life. Let’s discuss those factors.
Market conditions for investing are highly dependent on the overall economy. Investors always need to determine what asset classes to invest in. The top three are stocks, bonds, and cash.
Managing Risk Versus Reward: Asset Classes and Inflation
Market conditions for stocks have been positive so far in 2021, on the whole. The economy is fairly robust, despite increasing inflation, gas prices, and the lingering effects of COVID-19.
But prospective investors should understand that stocks don’t always do well. It’s the nature of stocks to fluctuate: they can decline in value as well as rise. You can lose money with stocks, and this makes them very different from cash.
If you keep a cash account (such as a savings account) in a bank account insured by the Federal Deposit Insurance Corporation (FDIC), for example, it is insured for up to $250,000. You won’t lose money that way, even if the bank goes bust.
Stocks, then, carry risks that neither cash nor bonds do. So why invest in stocks at all? Because on average, stocks may have higher returns than either bonds or cash. In the last 100 years, stocks have returned roughly 10 percent per year on average, even accounting for yearly declines in the broad-based stock market averages periodically. (1)
Stocks may be the only asset class whose returns have the potential to outpace inflation. Inflation usually runs at about 2 percent annually (and recently, it’s been higher than that). The returns of both bonds and cash are currently at historically low levels, of roughly 1 percent annually.
What that means from an investment standpoint is that your money is losing at least 2 percent of its purchasing power per year from inflation. Over a decade, in other words, it may lose 20 percent of its purchasing power. Stocks are usually needed in a portfolio to counterbalance the effects of inflation on investments.
The process of asset allocation is balancing risk and reward. Stocks may reward with relatively higher appreciation potential but pose higher risks of volatility and price drops. The risk can be balanced by allocating part of your portfolio in bonds or cash. They are both stable investments.
Bonds may fluctuate some when interest rates change (the price will drop if interest rates rise), but the fluctuation is usually minimal. Cash never fluctuates. But again, they carry little reward in terms of returns, because of the relatively low-interest rates.
Your stage of life also plays a role here. Pre-retirees and retirees may need relatively more stability in their portfolios and less risk than younger people. Why? Because of the potential of bear markets (overall stock market declines of 20 percent or more). That can severely impact the timing of retirement and the ability of retirees to live comfortably on their retirement portfolios.
With considerations of market performance, the risk versus reward, asset allocation, and inflation in mind, let’s not leave out personal considerations!
Your personal goals are a huge part of investing. What you plan to do in retirement, for instance, has a significant impact on how much you need to save for it. If you want to travel intensively, you may need much more money than someone who plans to stay in Libertyville, IL, and start a business.
Discuss your personal goals with a financial advisor so that your investments and investment strategy are aligned. He or she can help to create a comprehensive financial plan with your unique goals targeted.
Your Current Finances
The other personal consideration is your current finances. A financial advisor can work with you to establish a current budget and to forecast a retirement budget. A budget is a record of your income and expenses.
With a budget, you know how much disposable income you have to put toward investments. If you need to increase your investments for retirement, a budget can help you see where you might cut back on expenses to do so.
It’s also prudent for retirees and pre-retirees to have an emergency savings of three to six months’ living expenses. If you have outstanding debt, it’s also a wise move to pay down debt as much as possible. Debt service, especially if you have high monthly payments, can make both savings for investments and living comfortably challenging.
Fine-Tuning Your Investments: A Checklist
Now, armed with both market considerations and personal considerations, here’s how to approach investing.
1. Maximize any employer contributions
If your employer contributes to your retirement funds, take steps to maximize those contributions. If you don’t, you’re passing up free money. If you have a 401(k) and your employer will match any contributions, for example, contribute the maximum you can!
2. Diversify your investments
Part of managing risk in the stock market is not only allocating the asset classes in your portfolio. Diversification within investment classes is also important. Your stock investments should be spread among sectors and companies. If there’s an economic downturn in one sector, you don’t want all your stocks to drop as a result.
Also, while investing in company stock can be a good idea (especially if your employer offers a match or a discount on purchases), it is never a good idea to make company stock your only stock. It presents a risk: if the company encounters choppy waters, you could lose value in the stocks, and possibly your job if the company has to cut back.
Mutual funds and multiple stock picks can help diversify your portfolio. Similarly, discuss diversification of stocks and cash accounts with an advisor.
3. Dollar-cost averaging
Because stocks can fluctuate, investors are often anxious about purchasing. What happens if you purchase and then the stock market falls significantly?
That’s a very good question. One of the chief methods of ensuring that investors don’t do this is called dollar-cost averaging. Using this method, you purchase a certain amount of stocks periodically (often every month). That dilutes any risk that you will purchase only at a high.
In addition, dollar-cost averaging ensures that, if stocks fall, some of your purchases will occur at lows. That provides you more potential for upside appreciation in the stock.
If you’re in the Greater Chicago, IL area, make an appointment and we can discuss what to consider before investing.
At Prism Planning Partners, located in Libertyville, IL, we are CERTIFIED FINANCIAL PLANNER™️ Professionals committed to facilitating important questions so that we can help you explore all of your opportunities. We offer a broad array of holistic financial planning and consulting services for our clients-including retirement, investment, and estate planning.
Contact us today and let us illuminate your possibilities!
- https://www.nerdwallet.com/article/investing/average-stock-market-return published 8/11/21.
Written by: James Royal, Ph.D. and Areille O’Shea