Basics of Investing: Preparing to Invest

Determine your investment profile
Determine your time horizon
Determine your risk tolerance
Balancing risk and reward
Develop an investment discipline

Determine your investment profile

Making investments to build the assets you will need for your financial future is not just about understanding the investment options available to you, it's also about taking the time for some introspection to determine your goals and objectives.

What's important to you? Saving for a child's college education? Retirement? A vacation home? What's your time horizon for achieving these goals — one to two years or many years down the road?

You'll also need to realistically assess how disciplined a saver you are. Do you spend more than you earn? Do you carry high credit card balances each month? Do you set aside money each payday into your emergency fund? Do you have discretionary income (money left over after you've put money into your savings account and have paid your bills) that can be used for investing?

Last but not least, you'll need to define your tolerance for risk. How do you feel about the possibility of losing some or all of your money? Are you willing to accept a larger degree of risk for a potentially higher rate of return?

Defining your investment "personality" is the first step when preparing to invest. All of your saving and investment decisions will be built upon this foundation. Once these factors are known, you can begin to develop a consistent system for investing.

Determine your time horizon

Determining your time horizon for achieving your goals plays a big part in the types of investments you choose.

Those with short-term goals (one to two years) should consider relatively safe, non-fluctuating-type savings accounts such as banks, CDs and money market funds because you can't risk the loss of your savings due to stock market fluctuations or other economic factors outside your control.
Those with long-term goals (five-plus years) should consider investments such as stocks, bonds or mutual funds — investments that incur a greater degree of risk, but also offer the potential for greater rewards, as well.

The difference in investment choice is due to the time factor — the longer you have until you need the money, the more time you have to ride out economic cycles and market fluctuations.

Determine your risk tolerance

Generally speaking, the greater the amount of risk in an investment, the greater your potential reward, or return. The point where you stand on this risk/reward spectrum depends on your age, family situation, current and expected future income, tax bracket and overall net worth and determines the types of investments you should consider. For example:

Low risk
You are concerned about the return of your money, not the return on your money.

Certificates of Deposit (CDs)
Money market accounts or funds
Fixed annuities

Moderate risk
You want to keep ahead of inflation and understand there could be losing years.

Bond funds (government and corporate)
Balanced funds (blend of stocks and bonds)
Income funds (dividend-paying stocks)

High risk
You are able to withstand significant losses with the potential for better-than-market returns.

Growth and income funds (stocks with some growth and dividends)
Growth funds (higher risk)
Global/international funds
Sector funds (invests exclusively in one area of the market)

It's unusual for an investor to fall completely within one risk category. Many times, portions of investment dollars will be earmarked towards all three risk categories reflecting different goals and their respective time horizons. It's also important to note that your investment profile may change over time reflecting changes in your personal situation.

Balancing risk and reward

As the Investment Pyramid illustrates, risk varies among types of investments. Bank savings accounts, CDs and life insurance programs represent the foundation of your savings program and carry a low amount of risk. Consequently, they provide a lower return on your investment.

As you ascend the investment pyramid, stocks represent a higher degree risk because of the unpredictable forces that govern the rise and fall of the stock market — namely, interest rates, world events, company and industry performance and many more.

Develop an investment discipline

Regardless of where you fall on the risk/reward spectrum, being a disciplined investor can really pay off big. That's why it's important to create a system to regularly set aside money to invest. You will be surprised at how quickly those savings add up if you do the following:

When you pay your bills, put yourself at the top of the list. A general rule is to try to save 10 percent to 12 percent of your annual gross income.
If your employer has a payroll deduction program for savings, such as a 403(b) or 401(k), take advantage of it. Saving becomes convenient and consistent — and, since you don't actually see the money, a painless part of your monthly budget
The concept of dollar cost averaging can help boost your purchasing power. Each month (or pay period), you contribute a specific but equal dollar amount to your investment program to purchase mutual fund shares.

As market prices fluctuate, you will end up buying more shares when prices are lower and less when they are higher, effectively lowering your overall cost of shares.

Dearborn & Creggs Can Help

Spending the time now to determine your investment profile will help you design a solid savings and investment program. Your Dearborn & Creggs financial representative will provide you with valuable assistance in helping you define your goals and objectives and with determining your risk profile in order to create a manageable and consistent way for you to save and invest.