Understanding the role of risk
Investing involves risk, including the risk of loss. Oftentimes, risk is misunderstood. Not all risk is bad, and if you're smart with it, it can be a useful tool—in finances and beyond. Understand the ins and outs of risk to be smart when deciding how much risk is right for you.
More risk means the potential for more reward, and vice versa
Risk and reward have an inverse relationship. There’s no such thing as an investment with consistently high returns and no risk. Each investment type carries different levels of risk. You can use a mix of stock and bonds to your advantage. Combining investments with different risk/return characteristics to improve return potential for a given level of risk is called diversification.
Real vs. hypothetical gains and losses
Your gains and losses aren't realized until you withdraw money from your account. Say you purchased a single share of a company for $10 and it doubles in value over the course of a year. If you sold that share for $20, you'd make $10 in profit. Any increased value of your holdings is "realized" when you sell your holdings. Until then, any appreciation is considered "unrealized" gains. Same goes for loss. Let's say the stock you bought at $10 lowered in value to $1. If you sold now, you'd realize a $9 loss (the difference you bought and sold for). But if you hold onto that stock for 10 more years, it could regain its original value of $10 and have the potential to exceed the price you bought it at, resulting in a profit.
Stay the course, if you can, during market downturns
History shows that investing in stocks and bonds rather than sitting in cash can make a significant difference in investors' long-term success. When you buy and hold investments for the long haul, you put time on your side and allow your investments to have the potential to recover from downturns and perhaps regain their value.
Historically, the market has risen steadily over time
The financial crisis of late 2008 and early 2009 when stocks dropped nearly 50% might have seemed a good time to run for safety in cash. But a Fidelity study of 1.5 million workplace savers found that those who stayed invested in the stock market during that time were far better off than those who headed for the sidelines. From June of 2008 through the end of 2017, those who stayed invested saw their account balances—which reflected the impact of their investment choices and contributions—grow 147%. That's twice the average 74% return for those who fled stocks during the fourth quarter of 2008 or first quarter of 2009. While most investors didn’t make any changes during the market downturn, those who did made a fateful decision with a lasting impact. More than 25% of those who sold out of stocks never got back into the market and missed the gains that followed.
But how do you keep calm and carry on when it comes to investing?
Start by investing appropriately for your goal's timeline. Doing so can give you the confidence to stick with your plan—even when the markets get bumpy.
Invest for the long-term
Your time horizon—how long you have until you need your money—is really important. It's a big factor in deciding how much risk you feel comfortable taking on. Say you don't need to access your money in the next few years. In that case, you may be comfortable taking on more risk than you would if you needed that money sooner. When you're a "buy-and-hold" investor, you hang on to your investments for the long-term. The market will inevitably hit some rocky patches. However, your longer time horizon gives you a chance to ride out any short-term market declines.
You can't control the stock market, but you can control how much risk you take on. Your asset allocation strategy—your investment mix among asset classes such as stocks, bonds, and short-term investments—is a key way to control risk. Each asset class offers different risk and return characteristics and there can be a range in risk/return even within each asset class:
- Stocks tend to be the most volatile among stocks, bonds, and cash, according to historical data.They can be up one day and down the next to a greater degree than bonds and short-term investments, but history suggests they offer the greatest return potential.
- Bonds are generally more stable, but they have a lower return potential.
- Short-term investments can easily be converted to cash. Among the universe of short-term investments, U.S. Treasury bills, are backed by the full faith and credit of the U.S. government.
Commit to an ongoing balancing act
Asset allocation is not a set-it-and-forget-it exercise. You'll want to revisit it periodically, or if your goals, investment horizon, or financial situation changes. Once you've set the percentages of how much you want to be invested in stocks, bonds, and short-term investments, they will likely shift as some investments do well and exceed the proportion of your portfolio that you allotted for them. Other investments may shrink. Getting your asset allocation back on track is known as rebalancing.
Give me an example
Let's say you set your mix to invest 50% of your money in the stock market and, over time, that percentage increased to 65% due to market growth. To avoid taking on more (or less) risk than is appropriate for your time horizon, financial situation, and risk tolerance, you may want to make changes to bring it back to your 50% target.
How frequently should you rebalance?
It depends on what makes you comfortable, but generally you should check in periodically, whether annually or quarterly, and consider resetting your allocation if it has strayed from your original plan.
Investing doesn't have to be confusing or intimidating
With the road map provided by a basic asset allocation plan, you might find that planning your investments isn't so complicated after all.