Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you’ll see that the most important principle on which to base your investment education is simply good common sense. You’ve decided to start investing. If you’ve had little or no experience, you’re probably apprehensive about how to begin. It’s wise to educate yourself, so you can ask good questions, the better you understand the advice you’re given, the more comfortable you will be with the course you’ve chosen.
Don’t be intimidated by jargon.
Don’t worry if you can’t understand everything. Have a look at the glossary and find explanations in easy to understand terms so you know exactly what you are investing in.
Diversify – don’t put all your eggs in one basket.
This is the most important of all investment principles, as well as the most familiar and sensible. Consider using several different classes of investments for your portfolio.
Investments often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.
Recognize the trade-off between the risk and return of an investment.
For present purposes, I define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.
When someone proposes an investment and suggests otherwise, I know, “it’s too good to be true.” Invariably, the lowest-risk investments will be among the lowest-returning at any given time. The highest-risk investments will offer the chance for the highest returns. Between the extremes, every investor searches to find a level of risk–and corresponding expected return–that he or she feels comfortable with.
Understand the difference between investing for growth and investing for income.
As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income–or a little of both?
Consistent with this investor choice, investments are frequently classified or marketed as either growth or income oriented. There is no right or wrong answer to the “growth or income” question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate an education fund, not to be tapped for 15 years).
Understand the power of compounding on your investment returns.
To help make an educated “growth or income” decision, you should have a feel for the result of either approach. With an investment made primarily for the production of current income, you’ll know in advance the size and timing of payments to expect.
To evaluate the “growth” approach, you’ll need to appreciate the concept of compounding. Compounding is what happens when you “let your money ride.” Unlike the income investor, who usually takes his or him money “off the table” as the checks arrive, the growth investor lets investment returns remain invested, thereby earning a “return on the returns.”
A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a “rolling snowball” effect seems to operate, and the compounding’s long-term boost to investment return becomes dramatic.