As discussed in Chapter 1, because inflation eats away at the value of your savings and the power of compound interest is greater the higher your return is, you don't want to put all your savings in cash equivalents. Investing in stocks and bonds means taking on the risk that you will lose some or all of the money you invest. But there are ways you can minimize this risk.
One of the best risk management tools is diversification. Ever heard the expression Don't put all your eggs in one basket? If all your money is invested in the stock of Company A and Company A goes out of business – poof, there goes all your money. But if your money is invested in many different places, the loss of stock from Company A will not affect you as much. A well-balanced portfolio contains investments in all three investment classes and has diversity within each investment class. For example, you can purchase stocks from manufacturing companies, technology-oriented companies, and financial services companies.
What percentage of your savings should be invested in stocks vs. bonds vs. cash equivalents will depend on the timeframe of your goals. The closer you are to a goal, the more conservative (i.e., higher percentage of savings in cash equivalents and lower in stocks) your investments should be. Allocation may also vary due to risk tolerance. Some people have absolutely no problem investing in the stock market. Others pace nervously and go online once a day to see what their stocks are trading at. While your risk tolerance may dictate that you prefer one type of investment over another, remember that it is rarely a good idea to have your entire investment portfolio in just stocks, bonds or cash equivalents.
A simple way to get diversity is to purchase shares in a mutual fund. In a mutual fund, money from several investors is pooled to buy different stocks, bonds, and/or cash equivalents. Index funds in particular are recommended by many financial experts – instead of having an advisor that picks what investments are included, index funds track a particular index, such the S&P 500. This keeps the costs, and therefore the fees you are charged, lower.
Remember to Adjust
Once you set up an investment portfolio, you cannot just sit back and forget about it. You will probably need to make adjustments periodically as you get closer to your goals. The asset allocation for the retirement fund of a 30 year old should not be the same as a fund for a 60 year old. Your goals may change in the future as well. While you should not buy and sell too frequently, don't be afraid to make changes to meet your needs. Some time-sensitive retirement funds will automatically adjust your portfolio toward more conservative allocation as you get closer to your projected retirement date.
Dollar Cost Averaging
Some financial experts also recommend dollar cost averaging as a way of minimizing risk. Under dollar cost averaging, you invest a fixed amount at set intervals, e.g., $600 every three months. By doing this, you avoid "chasing" financial markets - the natural but counterproductive instinct to invest more when prices go up and invest less when prices go down. However, some financial experts believe that if you have a long timeframe, it is best to invest all that you can as soon as possible because, in general, the value of investments rises over time. By delaying investing, you may miss out on profits.