You’ve heard me and every other financial person say it before: Spend less than you make and save. It’s a fundamental of personal finance, but then what? Once you’ve done the savings part, what are your next steps with the money?
Today’s the fifth and final episode of my “Back to Basics” series about being brilliant at finance’s basics or core principles. So far, I’ve covered the Thrift Savings Plan, cash flow, saving smarter, and insurance. Today, I’m diving into a topic that can make or break your financial future: investing fundamentals. Investing wisely is a centerpiece for building wealth and reaching financial goals.
In this episode, I’ll cover:
- The basics of investing terminology
- Types of investments
- Understanding risk and return
- The power of diversification
- Compounding and its benefits
- Asset allocation strategies
- Key investment strategies
What’s Investing?
Let’s start with what investing is. When you invest, you’re carving out some of your money or resources to invest in assets with the hope of generating a profit or a financial return over time. This can include buying stocks, bonds, or real estate. It’s a way to build wealth by using your money to earn more money in the future.Types of Investments
Now for the different types of investments. Investments are specific types of assets you buy with the expectation that they’ll increase in value or make you money. All investments are assets, but not all assets are investments. For example, your personal property or cash under your mattress are assets, but they aren’t intended to make you money. Investments are assets specifically intended to grow your wealth. Here are the main types of investments and how they work.Stocks
Shares of ownership in a company. When you buy a stock, you become a part-owner of that company and have a claim on part of its assets and earnings. Stocks are traded on stock exchanges, which are marketplaces where buyers and sellers come together to trade shares of publicly listed companies. New York Stock Exchange (NYSE) and the Nasdaq are the two major exchanges in the U.S. Here’s the way stocks work. If the company you bought stock in does well, the value of your stock might go up, and you can make money. If the company does poorly, the value of your stock might go down, and you could lose money. Stocks can offer higher returns but come with volatility. You’ll want to have volatility on your radar. It’s a measure of how much the price of something, like a stock or investment, goes up and down over time. Even with its ups and downs, historically, investing in the stock market has provided higher returns than other investment types.Bonds
Bonds are debt instruments, meaning they’re like loans you give to companies or the government. In return, they promise to pay you back the amount you loaned them with interest over a set period of time. Bonds are generally less risky than stocks and provide regular interest income. They’re put into categories based on who issues them, like corporate bonds, municipal bonds, and treasury bonds. Here’s how bonds work. When you buy a bond, you’re loaning money to a company or government. The face value, also known as par value, is the amount of money a bond will be worth when it matures, and the amount the bond issuer or the company you loaned the money to, agrees to pay back to the bondholder, which is you, at that time. It is also the amount used to calculate the bond’s interest payments. For example, if you buy a bond with a face value of $1,000 and an interest rate of 5%, you’ll receive $50 in interest each year. When the bond reaches its maturity date, you’ll get back the $1,000 face value.Mutual Funds
Mutual funds are when you pool your money with many other investors to buy a diversified portfolio of stocks, bonds, or other investments. They’re managed by professional fund managers and are a great way to get diversification. If you’re not familiar with diversification, I will break that down in just a minute. Mutual funds come in various types, including equity or stock funds and bond funds. Index funds, which track the performance of a specific market index, like the S&P 500, are also mutual funds. Mutual funds allow you to diversify your the money you invest.ETFs (Exchange-Traded Funds)
ETFs are similar to mutual funds. The only difference is they’re traded on stock exchanges like individual stocks. ETFs also offer diversification like mutual funds but have the flexibility of stock trading. Plus, they often have lower fees.Real Estate
Real estate investing involves buying property, like houses, apartments, or land. You can earn money by renting out the property, which is rental income or selling it for a higher price than you paid, which is appreciation. FYI. Real estate investing requires significant money and management, but it can be a physical asset in your portfolio or basket of investments.Commodities
Commodities are physical goods like gold, oil, or agricultural products. They can act as a hedge or an insurance policy against inflation, which is when the price of everything goes up. Commodities are traded on commodity exchanges.Understanding Risk and Return
When you’re investing your hard-earned money, it’s important to understand risk and return and their tradeoffs. They’re the yin and yang of investing.Risk
Risk is the potential for you to lose money in an investment. Different types of investments carry different degrees of risk. In general, stocks are riskier than bonds but offer higher potential returns. Understanding your risk tolerance is crucial for choosing the right investments for your portfolio. Your risk tolerance is how much potential loss you can stomach. If you have a higher risk tolerance, you’re comfortable taking bigger chances with your money to make more money. You’re able to handle the ups and downs of the market. If you have a low-risk tolerance, you aren’t comfortable with taking chances with your money. You’re fine with lower returns in exchange for safer investments without as many ups and downs.Return
Return is when you either gain or lose money on an investment over a certain period of time. Returns can come from capital appreciation, dividends, or interest. Capital appreciation is the increase in the value of your investment. Dividends are payments made by a company to its stock shareholders. Interest is the cost of borrowing money. It’s a percentage of the amount borrowed that’s paid to the lender. It’s important to consider and weigh both the potential returns and the risks involved in any investment.Risk-Return Tradeoff
Be mindful of the fact that higher potential returns come with potentially higher risks. Finding your right balance between risk and return is key to your successful investment strategy. For example, if you’re an 18-year-old new recruit with a lot of years between you and retiring completely, you might take on more risk. If you’re 55 and getting close to retirement, you might prefer to play it safer with your investments.The Power of Diversification
Diversification is basically not putting all your eggs in one basket. It means spreading your investments across different asset classes and sectors to reduce risk. By diversifying, you can lessen the impact if your one investment performs badly or completely tanks. You can achieve diversification by spreading your investment out in one asset class, like stocks or bonds. For example, you could invest in individual stocks but spread your investments out into different sectors of stocks, like energy or information technology. You could also diversify by spreading your investments across different asset classes. For example, you could have a mix of stocks, bonds, and real estate. This approach helps protect your portfolio of investments from market volatility and reduces the risk of losses.Importance of Investment Horizons
Your investment horizon is the length of time you plan to hold an investment. Longer horizons allow for more risk-taking versus short-term goals may require being more conservative to preserve your investment. For example, if you’re investing for retirement 30 years from now, you can afford to take more risk and invest in stocks. On the other side, if you’re saving for a down payment on a house in the next five years, safer investments like bonds or high-yield savings accounts would be better.Compounding and Its Benefits
In the third part of the Back to Basics series, episode 291, I touched on compound interest. Compounding is when you earn a return on both your original investment and the returns previously earned. The earlier you start investing, the more you benefit from compounding. That compounding will significantly boost your wealth over time. Let me repeat for effect. The earlier you start investing, the more you can take advantage of compounding to have greater wealth in the future.Asset Allocation Strategies
Asset allocation involves dividing your investment portfolio among different asset categories like stocks, bonds, and cash. It’s based on your individual risk tolerance, goals, and investment horizon. Regularly reviewing and adjusting your asset allocation ensures it aligns with your changing goals and risk tolerance. A well-diversified portfolio might include a mix of stocks for growth, bonds for stability, and cash for liquidity. As your financial situation and goals change, you should adjust your asset allocation to ensure it remains aligned with your objectives.The Impact of Inflation
Inflation is when the prices of goods and services go up over time, which means the money you have can buy less than it used to. A dollar today does not go as far as it went last year. Inflation matters in investing because your investments need rates of return that outpace inflation to maintain purchasing power. For example, inflation is currently around 3%, which would me your investments need to earn more than 3% just to maintain their real value. Real assets like real estate and commodities can be good hedges against inflation.Key Investment Strategies
Investment strategies are guides for how and where to invest your money. They’re important because they help you make informed decisions, manage your risks, and achieve your financial goals more effectively. Here are some different types of strategies. Growth Investing – Focusing on companies expected to grow at an above-average rate. Value Investing or Warren Buffett style – Seeking undervalued stocks priced lower than their intrinsic value or what the stock is truly worth. Income Investing – Prioritizing investments that generate regular income, such as dividends or interest. Index Investing – Investing in index funds that track a market index. Diversification – Spreading investments across various assets to reduce risk. Dollar-Cost Averaging – Investing a fixed amount regularly, regardless of market conditions. Buy and Hold – Purchasing investments and holding them for a long period. Active Trading – Last and not recommended is active trading – Frequently buying and selling to take advantage of market fluctuations.Recapping Investing Fundamentals
Now for the wrap-up on investing fundamentals. By understanding the basics of investing, like the terminology, different types of investments, and risk and return, you can make informed decisions that will help you grow your wealth over time and avoid mistakes along the way. It’s a wrap for my “Back to Basics” personal finance series. I hope you found these episodes helpful and a kick in the pants to go after your financial goals. The journey to financial success is your own journey and it’s a marathon, not a sprint. Be patient and kind to yourself, but also hold yourself accountable and committed to your financial goals. You can do it! If you want to explore investing some more, I have some articles that I’ll link to in the show notes. Thank you to Navy Federal for providing support to the MILMO Show. You can also head over to milmo.co to get all of the resources and links from this episode, and while you’re there, be sure to sign up for the MILMO Memo newsletter to get all my updates. If you found this show helpful, please subscribe and share, please and thank you! I appreciate you listening. I’ll talk to you next week. Related episode: What You Should Know About Investing in I Bonds- Back to Basics Series Part 1- Thrift Savings Plan Basics for Service Members
- Part 2- Back to the Basics: Managing Cash Flow
- Part 3 – Back to the Basics: Save Money Smarter
- Part 4 – Back to the Basics: Insurance
