A Lot of People Don't Understand What an Investment Really Is. Do You?
We recently covered what money really is, and how you can harness it to suit your needs. Now it's time to take a look at investing. What is an investment, exactly, and how can you make an investment strategy work for you?
First, let's start with a definition. An investment is something bought with the expectation that it will rise in value or generate income, like stocks, bonds, real estate, or precious objects (I don't recommend the later, by the way). Let's start with rise in value.
An Investment Will Rise in Value
It's important to understand that the value of an investment is expected appreciate or rise in value over time. It's a tried and true sales technique to convince a buyer that what's being sold is an investment when really, it may not be. Here's the rule of thumb: If the item is expected to depreciate or lose value over time, it is a capital expenditure, not an investment.
That doesn't mean there aren't useful reasons to buy an expensive suit, a new car, or updated kitchen appliances. Those types of purchases will lose value over time, but they make life enjoyable or could even enhance a professional reputation (because in some industries clothes really do make the man). However, a buyer should know if they're purchasing with the intent to make money in the long run, or if they're splurging because they want to enjoy the utility of the item.
Examples of investments that one could expect to rise in value over time include corporate stocks, mutual funds, real estate, and precious objects like art, jewels, or collectibles.
An Investment May Also Generate Income
Sometimes an investor is less interested in the capital appreciation of an investment and more concerned with the income potential it can provide. That doesn't mean that income generating investments won't rise in value over time (the most attractive investments do both).
Examples of income generating investments include corporate stocks that offer a dividend payment, bonds (corporate, government, or municipal), and real estate bought for rental income.
Most important, though, is how you can use an investment strategy to get what you want out of life, or to get where you want to go. Here's how to use an investment strategy to build the life of your dreams.
1. Determine Your Goals
When it comes to investing, it's easy to put the cart before the horse. Many people start an investment plan without stopping first to think about why they're putting their money away in the first place. Knowing what you want can help you develop focus and focus leads to increased productivity and drive.
When many people think about setting up a savings and investment strategy, they focus on all the ways they'll have to deprive themselves to reach their goals. Sure, you may give up some small luxuries along the way but a look at the bigger picture can be truly liberating. Saving and investing can help you achieve your long term goals and give you the freedom to live your life the way you want to live it.
Whatever you want — a boat, a happy retirement, a paid-off mortgage — figure it out first, before you start saving a dime. Sit down and write down exactly what you want out of life. Writing it down will set an intention, which will help get your plan into motion. Once you've penned your life's goals, think about how much each goal will cost. Use an online calculator for help. Only once that information is all down on paper can you start mapping out your investment strategy. (See also: 6 Steps to Achieving All Your Goals)
2. Know How Much Time You Have
Short-, medium-, and long-term goals should be treated differently when planning a money strategy. The more time you have to invest, the more risk you can take on. This is because you'll have more time to recover from any market losses. The options for a 50-year-old who wants to retire in 15 years are different from those of a 25-year-old who has 40 years left until retirement.
5 Years or Less
Don't mess around with money you're going to need in the short term. No one can predict when the market will tank (or boom) and short term investors could find themselves with a fraction of what they expect if they find themselves on the wrong side of an economic cycle. If you expect to use the money within the next five years, it's better to forego potential market gains. Instead consider safer investment options like a savings or money market account or a Certificate of Deposit. (See also: The Basics of CD Laddering)
5 to 10 Years
An intermediate time frame allows for some time to recover from market volatility. A balanced portfolio of stocks and bonds can leverage equities to take advantage of a rising market while using fixed income securities to safeguard against a market in decline.
10 Years or More
A longer time frame can give investors more time to recover from a falling market, making a stock-heavy portfolio safer for those with plenty of time until they'll need access to their money (like for retirement planning). (See also: Using Time Horizons to Make Smarter Investments)
3. Assess Your Tolerance for Risk
No matter your available time frame, it's important to understand how you personally react to market volatility. Even a well-planned, diversified portfolio can lose 20% or more of its value in a given year, depending on the broad economic environment.
What would you do if your portfolio lost 25% of it's value over a four month span? What would you do with an unexpected $200 lottery winning? What is your general opinion of the stock market? It's important to know the answers to these questions and more like it before you plan an investment strategy.
There are many online calculators available to help you figure out your risk tolerance but here's one I've used.
4. Figure Out How Involved You Want to Be
Are you DIYer, or do you prefer a set-it-and-forget-it approach? You don't need to pay pricey advisor fees for either strategy (although there are plenty of great financial planners out there, if you do your reserach). Knowing how much time you want to spend learning about investments, monitoring your portfolio, and planning your short-term market moves will have a major impact on how you develop your investment strategy.
For those who want minimal involvement, there are plenty of target-date investment options available for a variety of goals including retirement and college tuition. A target-date fund takes care of all the heavy lifting for you. A portfolio manager selects the asset allocation (how much is invested in the different investments) and takes care of rebalancing as the portfolio grows and as you get closer to your goal. It's the most turn-key financial solution available today, and there are many low-cost options available. (See also: Easy Personal Finance For Lazy People)
If you like to get your hands dirty, there are plenty of places to dig in and start learning. Start by learning about securities (stocks, bonds, mutual funds) and how to develop an investment portfolio or get the inside scoop on real estate investing.
5. Get Into the Habit
If you want to be a successful investor, you need to make a habit of funneling money into your investment accounts. You can set up an automatic payroll deduction for most accounts or you can retrain your brain to get excited about the goal you're working toward. (See also: The Surprisingly Easy Way to Change Your Habits and Your Life)
Many investors get excited to save more once they have their goals laid out and firmly in place. It can become a game to find new ways to cut expenses and pad an investment account instead. (See also: How to Save $26,000 in 5 Years or Less)
While planning your investment strategy, remember that amassing a fortune is not the end goal. Your investments are a tool to help you reach your life's goals, whatever they may be.
What are your life's goals and how are you using an investment plan to help you reach them? Tell us about it in the comments!