The Foundation For Building Wealth
You don’t build wealth by saving, you build wealth by investing. This goes beyond semantics. Merely setting aside money regularly into a savings account will yield one to two percent. Invest in the stock market and you have the potential of your money growing between an average annual return of six to ten percent, depending on how and where you’re investing.
That amount compounded over time is one of the most effective ways to build real wealth. The kind of wealth that will withstand the effects of inflation eating away at your money over time.
Rick and Jody
Jodi left all financial decisions with her husband Rick. Rick hired Tim, his high school friend, who happened to be a stockbroker, to manage their assets.
Rick was a realtor and both him and Tom had a high tolerance for risk. The investments were for their retirement after all, which was not for another 20 years. Tim invested a high proportion of their savings in hi-tech companies. Things were looking good. This was in the late 1990s. But the hi-tech bubble burst. The value of their investment assets dropped by fifty percent.
Unfortunately, at that time Jody discovered Rick was having an affair and left him. They had to divide their assets as part of their divorce settlement, The forty percent drop in the value of their investments shocked Jody. It would not have been as bad if Jody could have left the investments to recover. But she needed the money.
How Tim invested Jody’s investments did not align with her objectives.
The Nuts and Bolts of Investing
How do you invest your money? Where do you start? This is the process of asset allocation. It is the strategy of allocating your assets into different asset classes.
There are four main investment classes
1. Cash and Cash equivalents.
2. Fixed Income – bonds.
3. Equities – stocks and shares.
4. Alternative Investments – precious metals, art, bitcoin.
Cash or Cash Equivalents
Bank accounts short-term deposits and money market funds are examples of cash and cash equivalents. Highly liquid, they convert to cash with no significant risk of change in value. You may earn some interest in the course of having your money in them – usually between 0.1 to 2%.
Fixed income investments give you a fixed amount of interest on a fixed schedule. Bonds are a popular type of fixed income. The issuer has to pay interest at a fixed rate at least once a year and to repay the principal amount on maturity.
The issuer may be the government – as in the case of federal or municipal government bonds. Or corporations – as in the case of corporate bonds.
If kept to maturity, you get the principal amount back while collecting interest at least once a year. Bonds can be safe if you keep them to maturity. With many bonds, the value of the bond may fluctuate before maturity. Corporate bonds are more volatile and riskier.
The third asset class is equities. Equities/stocks are shares of a company. When you buy stocks or shares of a company, you’re purchasing ownership in a company.
Of the three asset classes, equities generally have the greatest potential for growth. They are riskier than the first two. Equities are long-term investments for long-term goals providing an excellent hedge against inflation.
Even within equities, there is a wide range of investments. Blue-chip bank stocks are less volatile than mining stocks. International Equities are generally more volatile and more ‘risky’ than domestic stocks. Because they have the added dimension of currency risk.
Small-Cap stocks (stocks of smaller companies) are riskier than large-cap stocks. Large-cap stocks.
If you do invest in equities, you must be willing to tolerate fluctuations in your principal. With a long-term goal like retirement, you can afford to take some risks. A substantial portion of public and employer pensions are invested in equities to ensure that money contributed is going to grow to meet the needs of the huge number of pensioners that retire each and every year.
A conservative portfolio has more cash and fixed-income investments. An aggressive portfolio will comprise more equities. A balanced portfolio has all asset classes in it. With an almost equal amount of fixed income to equities.
These include bitcoin, derivatives, gold, and silver, and even art. These assets are not as liquid as the others mentioned above. They are also the riskiest. Investing is not an exact science and does leave room for individual interpretation.
Why Do You Need To Invest In All Four?
This is the basis of diversification. Not all four asset classes respond to economic conditions the same way. The different asset classes do not all move in the same direction at any one time. When there is news of uncertainty, then the stock market may correct. This may cause investors to move their investments out of equities and into fixed income for safety.
You need all four asset classes so that if there is downward pressure on one of the classes, the others may act as a buffer on your portfolio and prevent it from falling too far.
Where You Invest Your Money Depends On:
- your values
- the objectives for your life.
- the time in which you want to achieve your goals (Your Time Horizon for the investments)
- your tolerance for risk.
Your Time Horizon:
Your time horizon is how long you are willing to let your money remain invested before needing to use it. Short-term goals are those you hope to achieve within 3 years. Medium-term goals are those slated for between three to ten years. And long term goals are those you hope to achieve in another ten years or more.
Invest in more equities to achieve long-term goals like retirement.
One of the biggest “mistakes” people make is by investing in short-term vehicles for long-term goals. And investing in investments meant for the long term to achieve short-term goals.
Your Tolerance For Risk
Your tolerance for risk is your willingness to see your principal fluctuate in value without getting into a panic.
Your Overall Financial Situation
If you have a high tolerance for risk but have no other sources of income, you should still avoid putting the bulk of your portfolio into high-risk investments. If you had a financial emergency and need to use your investments, you do not want to be forced to sell off your investment if there was a prolonged downturn in the stock markets.
Back to Rick and Jody and some important lessons from this story:
It seemed at first that they had a long-term time horizon for their investments. Because of their separation. Jody needed the money sooner than planned.
The investments reflected Rick and his broker’s tolerance for risk rather than Jody’s. Did Tim even ask her what was important to her?
Did he do a risk tolerance assessment with her or was it just based on her husband?
Rick was a realtor with unpredictable income. It would have been better to have a lower risk portfolio to balance the uncertainty of Rick’s income
Was there an emergency fund created to deal with life’s unplanned events?
The portfolio dropped by 40%. It was an aggressive portfolio. Unless you are certain you will not need the money for a long time and have other liquid assets as a backup, you should not be in an aggressive portfolio.
Bringing It All Together
Investing is one of the best ways to increase your net worth and achieve your goals. You need growth if you have a long-term time horizon. If you are concerned about risk, ask yourself, “can you afford NOT to take any risks?”
Taking a risk does not always translate into a high return. But in general, equities have, on average, a better rate of return than cash equivalents. You need to take some risks if you hope to achieve your long-term goals. Work with an advisor who is aware of your objectives for your money and your tolerance for risk. One who can help you create a portfolio that aligns with your needs.
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Through coaching, webinars and public speaking Jennifer helps people and businesses discover how to achieve success on their terms. She has written numerous books on money: Women and Money: 7 Principles Every Woman Needs to Know to Be Financially Prepared in Any Economy and Growing Up With Money: Raising Financially Resilient Kids in an Age of Uncertainty.
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