Financial Planning - Investment
While experienced investors are aware of volatility and take it into account when determining which stocks to include in their portfolios, those without much experience are often afraid of losing money in the stock market. However, even with down years, stocks are still one of the best ways to increase wealth given a relatively long time horizon. Investors of all ages can and do benefit from having the proper percentage of their savings invested in stocks, stock mutual funds, or ETFs.
Investing in Equities
Those in their 20s and 30s can usually afford to take bigger risks with their equity investments. Because of the long time horizon, they can make up losses that occur in market downturns. They can also ride out periods of very low or no growth. While stocks that pay dividends are typically thought of as the domain of older investors, younger investors, too, can take advantage of dividends by reinvesting them. Rather than having the dividends paid in cash, they can opt to purchase additional shares of the stock each quarter when the dividends are paid. Dividend reinvestment increase the number of shares owned and guarantees that the price paid for the stock is averaged out over several time periods. In other words, because the price of a stock may fluctuate greatly over the course of a year, purchasing it every quarter means that an investor usually won't pay the highest – or lowest – price for it.
A good mix of equities is required for proper balance and allocation. Owning five or 10 stocks total, all in separate sectors will usually protect an investor from substantial ups and downs. The general rule of thumb is not to own two stocks in the same business. For example, don't own both Revlon and Estee Lauder, as both are in the Consumer Staples, Household, and Personal Products category.
Diversification Through Equity Mutual Funds
Given the rising price of a gallon of gas over the past several years, most Americans wonder if it's fair that big oil companies continue to post record profits. While it may not be, most Americans benefit from those record profits by owning mutual funds that own ExxonMobil (XOM). The top 50 institutional holders and top 50 mutual fund holders own over 40% of XOMs outstanding shares. That means chances are quite good that those who invest in employer-sponsored retirement funds or purchase mutual funds for their own individual retirement accounts or brokerage accounts profit in some way when large oil companies show big profits.
Regardless of how you feel about record profits and what those profits contribute to the share price of your mutual funds, the real problem with a large corporation like XOM is that it is owned by so many funds. This makes it extremely difficult for an investor to use mutual funds in the way they should be used: for diversification.
Always check to make sure that the top 10 holdings in each of the funds you own are not duplicated in other funds. If they are, your funds will give you a false sense of security rather than offering the protection of spreading risk across several sectors and stocks. And make sure that the top 10 holdings are companies that accurately reflect the goal of the fund. For example, it would not make sense for XOM to be included in a fund that specializes in small cap companies (companies that have a market capitalization between $300 million and $2 billion).
Why Exchange-Traded Funds Should be Part of an Investor's Portfolio
An exchange-traded fund is a fund that trades like a stock rather than a mutual fund. The price of a stock fluctuates throughout the day. Each time the stock is bought and sold, the price changes to reflect the supply and demand. This is often called a "tick". A stock can tick up or down just a few times during the trading period or it can tick up or down with every trade.
Mutual funds have only two prices during the day: the opening price and the closing price. If an investor orders shares to be sold at 10:00 a.m., the price the shares are sold for are not known until after the market closes and the closing prices of all of the stocks within the fund are known. This has been the standard trade-off between diversification and share price. If bad news comes out about XOM during the trading day and large institutional owners decide to sell the stock, the price will be driven down. The price of the mutual funds that hold the stock are also likely to go down if XOM makes up a large portion of the fund. Owners of the fund, however, can only wait until the end of the day to learn the new net asset value of their fund.
The price of an ETF can tick up or down with each trade. ETFs offer the diversification of mutual funds with the short-term trading potential of stocks. Many ETFs are also much more cost-effective than mutual funds because they are typically comprised of fewer stocks and don't require the same level of management. EFTs commonly feature 1-2% management fees whereas mutual funds often charge 2-3%. Some of the more popular ETFs are Select Sector SPDRs, Standard and Poor's 500 Index Depository Receipts, the Nasdaq-100, DIAMONDS Trust, which tracks the Dow Jones Industrial Average, and iShares Russell 2000, which tracks the Russell 2000 Index.
US Treasuries, Corporate and Municipal Bonds
Bonds are an important part of every investor's portfolio, especially those who are nearing retirement. While equities offer partial ownership of a company, bonds offer ownership of debt. Owning debt means lending the company (or the United States federal government, state or local municipality) money in exchange for guaranteed interest.
Bonds typically offer a much safer method of protecting interest and income than stocks. But bonds aren't always a sure thing. A bond is really only worth the credit rating of the company (or government) that issues it. A high credit rating of AAA means that there is little chance that a default on the debt will occur.
Soaring deficits, rapidly increasing costs, and an unwillingness to cut expenses may leave the United States vulnerable to a credit rating decrease. While this does not mean that the United States is likely to default on its loans, it does mean that purchasers of bonds would expect more interest in exchange for taking on more risk. Just as a credit card company or mortgage lender charges a consumer with a low credit score more than a consumer with a high credit score, so do people who buy debt in the form of bonds.
So bonds, just like stocks, are associated with risk. That is why diversification is so critical. All investors need to carefully assess the amount of risk that each type of investment presents and allocate appropriately.
While we've covered the basics of financial planning here, there is much more to implementing a financial plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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- Financial Planning FAQ — Frequently asked questions about financial planning.