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Wealth Care Kit: Investment Planning


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Wealth Care Kit: Investment Planning

  1. 1. WEALTH CARE KIT SM Investment Planning A website built by the National Endowment for Financial Education dedicated to your financial well-being.
  2. 2. W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g Do you have Investing, on the other hand, worth of goods 20 years from now! long-term goals means putting money into assets, Looked at another way, a $12,000 such as stocks, bonds, mutual funds, new car today will cost $21,673 in you’re uncertain and real estate, that historically have 20 years. Under these circum- earned a higher rate of return than stances, a savings account earning how to finance? common savings products. If you 3 percent will only break even in deposited $2,000 in a savings ac- terms of purchasing power. Subtract count at 3 percent annual interest, taxes on the earnings, and the it would grow to $3,612 in 20 years savings account will actually lose Are you a saver or an investor? Have (before taxes). The same $2,000 ground. you been reluctant to invest money invested in a stock mutual fund because you think the stock market earning an average 10 percent a year In addition to understanding is too risky? Do you want to know would grow to $13,455 in 20 years the different types of risks, it’s more about the fundamentals of (before taxes)! Investments are important to understand that the developing a sound investment usually selected to achieve long- willingness and ability to withstand program? term goals, such as paying for short-term price fluctuations college education or funding generates greater long-term This section contains information rewards. This relationship is that will help you answer some retirement. illustrated in the investment of these questions. It will explain: INVESTMENT RISKS pyramid on page 5. Stocks fluctuate • the difference between saving “But what about the risks?” you more than CDs, for example. With and investing may ask. stocks, you can lose part or even all • investment risks and how to of your investment in a short period Yes, every investment involves control them of time. Yet, over the long term, risk. Anyone who claims otherwise stocks on average have consistently • the different types of investments is either naive or trying to sell a lie. and substantially outperformed cash available Even so-called low-risk or no-risk and the thief of cash: inflation. savings alternatives involve risk. • how to match investments with Let’s look at two of the most HOW TO CONTROL your goals important types of risk. INVESTMENT RISK • ten keys to successful investing Market risk. The prices of stocks, If accepting greater risk is one of bonds, mutual funds, real estate, the necessities of investing, then one THE IMPORTANCE OF gold, and other investment assets of the keys to investing is controlling INVESTING rise and fall due to the economy, risk. Three controls on investment While people commonly use the risk are diversification, consistent investor sentiment, political events, words “saving” and “investing” investing, and time. changing interest rates, changes in interchangeably, there are the fortunes of companies or Diversifying your investments important distinctions. industries, and other factors. All means never putting all of your eggs Saving typically means putting investment assets fluctuate to some into one basket. A well-balanced aside money in “low-risk” passbook extent. This is the type of risk people investment portfolio involves savings accounts, money market most associate with investing. spreading investment funds among funds, or certificates of deposit (CDs) for short-term goals, such as Inflation risk. Inflation basically different types of assets, which buying a new car, taking a family means that receipt of a dollar might include stocks, bonds, real vacation, or establishing an tomorrow is worth less than receipt estate, cash or cash equivalents, emergency fund. It’s money you of a dollar today. Inflation is a silent and international investments, and want to be able to get to quickly, thief that, over time, can rob your investing in different securities easily, and with little or no risk that savings of significant buying power. within each type of asset. This you’ll lose what you set aside. For example, even at a modest 3 reduces risk, because even though percent annual inflation rate, one or more investments might $1,000 today will buy only $554 falter, others will gain.1 © 2001, 2005, 2009 National Endowment for Financial Education
  3. 3. “ W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g For example, if you have all of Owning stocks has disadvantages, your investment money in a single as well: asset, such as your company stock • Capital loss. As an owner, you’re purchased through a retirement plan, and the value of that asset DIVERSIFYING not guaranteed that you’ll get back all or part of your investment. plunges 50 percent, you’ve lost half YOUR INVESTMENTS of your total investment. However, if the company stock makes up only 10 percent of your portfolio, the total value of the portfolio would decline by only 5 percent. Meanwhile, other investments in the portfolio may be MEANS NEVER PUTTING ALL OF YOUR EGGS INTO ONE BASKET. “ • Volatility. In the short term, stocks tend to fluctuate in value much more than do bonds and cash equivalents. When you invest in a bond, you are lending money to a company, or the rising, so that overall the portfolio government, that promises (though grows in value. not necessarily guarantees) that it Another way to control risk is TYPES OF INVESTMENTS will pay back your principal with to invest consistently. One popular interest. Bonds include Treasury There are many types of invest- method is known as dollar-cost bonds, municipal bonds, and ments, but the most common are averaging. Each month, for example, corporate bonds. stocks, bonds, mutual funds and you invest a specific amount of cash equivalents. Advantages include: money, regardless of whether the • You receive a fixed stream of market is up or down. You’ll buy If you buy stock, you are buying income. some shares when it’s high, and a share of ownership in a company. some shares when it’s low, but since Advantages include: • Government and high-grade markets generally rise over time, • Capital appreciation. If you sell an corporate bonds have relatively little you’ll come out ahead. This is a good asset for more than you paid for it, risk of default. strategy because predicting the best you make what’s called a capital gain. The gain, potentially, could be • Yields usually are higher than with time for making an investment many times your investment and CDs and money market accounts. is so difficult. there may be tax advantages. • Some types of bonds, called Research also has shown that • Dividends. Many stock invest- municipal bonds, pay interest that is time reduces the risk of investing. ments provide a quarterly stream free from federal (and, in some The price of a given investment— of dividends, or income, from the cases, state and local) tax. particularly one in a more volatile category such as stocks—may rise company’s profits. Research has Disadvantages include: and fall within a short period of shown that unless you need current • Bond holders cannot share in the time. But over the long run, many income, it’s best to reinvest any growth of the company. investments gain back any losses in dividends to grow your investments. value…and then some. That’s why • Bonds can lose purchasing power Capital appreciation plus dividends investing is a long-term strategy for if interest payments are lower than equals the total return on your long-term goals (typically five years the combination of the inflation investment in common stocks. or longer) and why many invest- rate and your tax rate. Studies indicate that, over longer ment experts recommend that periods of time, common stocks • You can lose money on your investors buy and hold investments provide significantly higher total investment if you sell the bond instead of trying to guess whether to returns than bonds or cash before it reaches its maturity date buy or sell based on current market equivalents. (when principal is repaid) and indicators (known as market interest rates have risen since you timing). bought the bond. (When interest rates go up, bond prices fall.)2 © 2001, 2005, 2009 National Endowment for Financial Education
  4. 4. “ W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g Cash equivalents are short-term, Many people invest through interest-bearing securities such as their company retirement or savings CDs, money market accounts, and plan, such as a 401(k) or profit- Treasury bills. They fluctuate little, sharing plan. In these “qualified if at all, and you can convert them plans,” the investment earnings are to cash quickly and easily. However, A POPULAR WAY FOR tax deferred. Each plan typically their interest rates generally are close to the inflation rate, so cash equivalents serve best for short- term needs or as a temporary “parking place” until you move the money into more attractive MANY PEOPLE TO INVEST IS THROUGH MUTUAL FUNDS. “ offers a choice of investments, such as mutual funds, guaranteed invest- ment contracts, money market funds, and so on. Similar investment options can be found in individual retirement accounts, annuities, and investments. cash-value life insurance. Other types of investments include A GAME PLAN real estate (your home, commercial you learn through a fund’s prospec- Once you understand the property, etc.), precious metals fundamentals of investing, you tus exactly what objectives and (such as gold and silver), and energy can develop an investment plan or strategies the fund uses. (oil and gas). strategy. This involves first clarify- For the small investor with limited INVESTMENT PRODUCTS capital to invest, mutual funds ing your goals, such as early You can invest in a variety of ways. offer the advantages of diversifica- retirement, current income, or Stocks and bonds, for example, tion (each fund may hold from 25 saving for college education. How can be bought and sold individually to over 100 different securities), much money will you need to or through mutual funds. Real estate small initial investment (typically achieve these goals and how much can be bought directly or through $2,000), and professional manage- time do you have? Be as specific limited partnerships, which are ment. Trying to diversify by buying as possible. groups of individuals who gather for individual stocks, bonds, or other Next, define your investment the purpose of investing, or through securities usually requires more objectives. What types of invest- real estate investment trusts, which money, time, expertise and risk ments and what investment invest in real estate properties or tolerance, but the potential products will help you reach your mortgages and whose shares are reward can be greater. goals? If you have 30 years to traded like stocks. Another popular way to invest retirement, you may want to A popular way for many people is through Exchange Traded Funds consider investing the majority to invest is through mutual funds. (ETFs). ETFs are similar to mutual of your funds in aggressive growth Mutual funds pool money from funds with a few key differences. mutual funds through your 401(k) many shareholders to buy securities. An ETF mirrors the performance plan because they offer capital Mutual funds have different and diversification of a stock or appreciation and you’ll have time to objectives: some buy the stocks of bond index. Just as mutual funds ride out the ups and downs of the new or emerging companies that pool money from many investors to market. If you’re approaching may offer no dividends, but have buy securities, ETFs do the same. retirement, you may want to strong potential for capital apprecia- But while most mutual funds can consider less volatile investments tion; some funds invest in bonds only be bought or sold once a day at that will provide high current and dividend-paying stocks to market closings, ETFs can be bought income; but you’ll still need some provide current income for their and sold any time the markets are growth funds in your portfolio to shareholders; other funds focus on open, just like individual stocks or stay ahead of inflation during your overseas investments or on certain bonds. ETFs tend to have lower retirement years. industries or sectors of the operating costs than mutual funds, Whether you’re trying to reach one economy. There are countless and they are usually more tax goal or several, the combination variations, and it’s important that efficient.3 © 2001, 2005, 2009 National Endowment for Financial Education
  5. 5. W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g of investments you make is called A well-thought-out investment a portfolio. Your plan should state plan is critical, because you will use what percentage of the total it to monitor your progress. It also portfolio will consist of stocks, keeps you steady through good bonds, cash or cash equivalents, times and bad and helps you avoid international investments, precious those tempting “hot” investments metals, real estate, or other types of that really don’t fit your needs. investments you choose. How much you allocate to each category will Finally, if you work with an depend on your goals, risk investment adviser, make sure the tolerance, time horizon, age, and adviser helps you develop a written amount of funds to invest. A investment policy statement. diversified portfolio is more likely It specifies your investment goals, to reduce risk and stabilize return. risk tolerance, acceptable asset classes, and investment perform- ance measurement criteria. Ten Keys to Investment Success 1. Develop a plan and link 7. Take full advantage of tax- it to your financial goals. deferred retirement programs. 2. Diversify by owning different 8. Avoid buying any investment types of assets and securities. that claims you can earn a great return for little risk. If an invest- 3. Invest for the long term. ment looks too good to be true, it 4. Have realistic expectations. probably is. It’s rare to increase return 9. Take control of your investments. without increasing risk, Stay informed. Even if you work or vice versa. with financial professionals, 5. Never invest in anything you you must be the one ultimately can’t “sleep on.” responsible for your decisions. 6. Monitor the performance of your 10. Don’t invest in something you investment portfolio at least don’t understand. annually.4 © 2001, 2005, 2009 National Endowment for Financial Education
  6. 6. W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g INVESTMENT VEHICLE PYRAMID: RISK/RETURN TRADE-OFF on In Future contracts cre In ati cre i asi rec asi l ng cap cipa pp ng ris la rin Speculative Gold saf ita ko fp ety common stocks and f lo rinci so of ss and bonds collectibles for los p of al of pu nti isk rch pa ote Limited Real estate Puts gr l asi gp partnerships investment and calls sin ng sin rea properties (options) po rea Inc we Inc r High-grade Growth common stock mutual funds Balanced High-grade High-grade mutual funds preferred convertible stock securities High-grade High-grade Money market municipal bonds corporate bonds accounts U.S.-insured Treasury Life insurance EE and HH U.S.-insured checking and securities* cash values bonds certificates savings accounts of deposit * If held to maturity. Otherwise, they are subject to volatility due to interest rate risk as with any other type of bond. • Investment products at the top of the pyramid tend to be non-liquid and speculative in nature. • Investment products at the top of the pyramid offer a greater potential reward through capital appreciation, but also have a greater potential for the loss of principal. • Investment products at the bottom of the pyramid tend to be liquid (easily converted to cash with little principal fluctuation) and offer a stable, but lower rate of return. While investment products at the bottom of the pyramid pose little risk of loss of principal, there is little or no potential for capital appreciation. Because of this, if the rate of return is less than the rate of inflation, there is a risk that purchasing power may be lost over time. • Investment products in the middle of the pyramid offer a combination of moderate risk and return.5 © 2001, 2005, 2009 National Endowment for Financial Education
  7. 7. W E A LT H C A R E K I T: I n v e s t m e n t P l a n n i n g Growth in the U.S Stock Market A $100 INVESTMENT IN STOCKS IN 1979, WOULD TODAY BE WORTH OVER $2,300. Source: Lipper, as of June 30, 2005. Hypothetical gains (or profits) on stocks are based on returns of the S&P 500. It is important to remember that there are many ways to invest, and diversifying your investments can reduce risk. R a n k i n g Yo u r I n v e s t m e n t O b j e c t i v e s Before you can select an appropriate investment portfolio, you must first identify and rank your investment objectives. Several investment objectives are listed below. Rank these objectives from 1 (most important) to 10 (least important). After completing this ranking exercise, you will have a clearer idea of your investment priorities. Use this information when choosing investment products or when working with a financial professional. ______ Minimize the risk of loss of principal. ______ Maximize the potential for large short-term gains. ______ Ensure slow, stable growth to fund long-term future needs, such as retirement or a child’s education. ______ Maximize liquidity in the event funds are needed in a hurry. ______ Maximize current income to provide for current needs. ______ Reduce income taxes. ______ Build savings toward short- or mid-term major purchases, such as a down payment on the purchase of a home. ______ Maximize the value of your estate for your heirs. ______ Minimize the amount of estate taxes owed upon your death. ______ Protect assets from the claims of creditors or others. National Endowment for Financial Education, all rights reserved. CFP and CERTIFIED FINANCIAL PLANNER are federally registered marks of the Certified Financial Planner Board of Standards, Inc.6 © 2001, 2005, 2009 National Endowment for Financial Education