Investing involves risk. There is no getting around that. But a carefully considered investment plan should help address those potential risks while focusing on long-term growth. This approach relies on formulas, not emotions.
But even the best-laid plans can go awry when investors succumb to urges brought on by fear or greed, or even panic. Common missteps include trying to time market cycles. Sometimes investors get caught up in media hyperbole and rush to sell when their investments fall in value. In fact, this could be the time to buy. And sometimes people chase hot rumours by sinking money into investments that promise a big payoff.
Remember that even professionals can’t know when prices will go up and down. It’s far better to develop a solid plan and stick to it over the long-term.
Why it’s important to start investing at a young age
Time is a powerful tool in reducing risk and an important reason to start investing early. Generally, the younger you are, the more risk you can take on. As you get older, your portfolio should steadily shift to more conservative investing.
Financial markets can bounce around daily and sometimes they fall sharply. But historically, markets recover over time. If you focus on long-term growth you’ll be less inclined to worry when markets dip.
The value of mixing it up
Diversification is a bedrock technique for mitigating risk. Holding varied investments can help lower the emotional impact of panic or fear if one of those investments gets into trouble.
Take stocks. Owning shares in several companies spreads out risk. Low-risk investors may be willing to invest in a couple of higher risk technology start-ups with growth potential if the rest of their equity portfolio contains larger, more established companies.
Investing in different industries adds another layer of diversification. If energy companies are facing short-term problems because a warmer winter is causing natural gas prices to fall, companies in other sectors may benefit from the drop. Investing in different countries is another way to diversify your portfolio.
Mutual funds and segregated funds are common solutions for diversification. They contain shares from a large number of publicly traded companies and may specialize in specific industries or countries. Funds available cover the gamut of risk, from high-risk emerging markets growth funds to conservative funds.
Using diversification to your advantage
Asset allocation is another powerful diversification technique. Financial portfolios are divided into three main categories: equities, fixed income (which includes bonds) and cash. Fixed income investments offer less upside but they are generally more stable; this is especially the case when it comes to government or high-quality corporate bonds. Many people invest in bonds indirectly through mutual funds.
Cash is the third category. Cash or cash-like instruments, such as term deposits, offer limited but guaranteed growth. Individuals with a very low risk tolerance – such as people nearing retirement – may hold a significant amount of their portfolio in cash. Cash also offers a safe way to park money for shorter-term goals, such as saving to buy a house.
The financial challenges of aging
As you age, your investment horizon shortens. At 25, you can assume more risk in your portfolio. But you can’t rely on time to smooth out the bumps once you’re approaching retirement. That means moving to less aggressive investments and increasing your holdings of fixed income investments and cash. You’ll be less likely to make rash investment decisions amid fear about losing your nest egg.
Thoroughly examine your overall investments once or twice a year to make sure asset allocations remain at desired levels. A jump in stock prices can be good for your portfolio but you may find yourself overly invested in equities and needing more conservative investment options.
Creating a sound investing strategy that allows you to spend less time thinking (or even worse, worrying) about money is a big part of enjoying financial independence.