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by Douglas Gerlach
Are you ready to start investing in stocks? Before you get going, there are a few essential concepts you should understand. Working with these basic concepts is the key to becoming a successful investor. Once you understand the potential risks, rewards, and how to balance your choices in the market, you'll have the right foundation to continue your education and pick stocks for your portfolio.
There Are No Guarantees
The first thing you need to know about investing is this: whenever you invest, whether in stocks, bonds, or even if you simply keep your dollars in a money market fund, there is no guarantee you'll make a profit. With some investments, you could even lose money, ending up with less than you started with. Armed with the right knowledge, however, you can improve your odds of success, balancing the risks of investing with the potential rewards.
Balancing Risk and Reward
Whenever you invest, you expose your money to some level of risk. You might not think about it, but there is risk involved no matter what you do with your money. Even stashing your life savings in a cookie jar or under a mattress comes with the risk that your money could be stolen (where do you think burglars look first when they rob a house?) or destroyed (you might be able to find a fireproof cookie jar, but your bed is definitely not safe in that department).
Investing in the stock market carries its own risks. A stock you purchase might fluctuate up or down in price. Stocks are volatile by their very nature (some more than others), and that's part of the inherent risk of this type of investment. In the worst case, a stock could become worthless and cause you to lose 100% of your investment. However, it's important to recognize that there are different kinds of stocks, and some stocks are riskier than others. You can't ever eliminate the risk associated with investing in stocks, but you can certainly tame it - and even put some of those volatile tendencies to work for your benefit.
Keeping Up with Inflation
There is another important kind of risk to consider, even if you're investing in bonds or just keeping your money in the bank. There's the risk that your investment won't grow fast enough to keep up with the effects of inflation. Over the years, inflation has grown at about three to four percent per year on average. If your money is sitting in a bank collecting interest at less than the rate of inflation, then that money will actually be worth less when you withdraw it at some point down the road.
Assuming a Reasonable Amount of Risk
Whenever you seek higher returns, you must accept higher risk. The key is to balance the amount of risk appropriate for your circumstances (what experts call your risk tolerance) with the amount of reward you want to achieve. Every person has a different tolerance for risk, and it's up to you to decide for yourself how to build a portfolio that will serve you best.
Historically, investing in stocks has offered the chance to earn higher returns than investing in bonds or keeping your money in the bank, but that opportunity comes with higher risk. The essence of successful investing, though, is understanding and accepting the fact that risk is unavoidable - and managing that risk so you can still sleep well at night.
Investing, Dollar by Dollar
An important concept that you can put to work when you invest in stocks is dollar-cost averaging. While this may sound like a complicated strategy, it's really not difficult to understand. When you use dollar-cost averaging, you automatically invest a fixed amount each week or month in the purchase of a security or group of securities. That's all there is to it!
Why is dollar-cost averaging a sound long-term strategy? Stock prices can be volatile, rising and falling from week to week and month to month. When you make a weekly or monthly purchase, the price of the stock may be higher or lower than it was the month before. If you invest $100 a month, for example, then your $100 will buy fewer shares when the price is high and more shares when the price is low -- automatically. While dollar-cost averaging does not assure a profit, over time the average cost of your shares will generally tend to be lower than if you had made a single one-time investment of the same amount.
You might be using dollar-cost averaging right now without even knowing it. If you invest in a 401(k) or other retirement plan at work, you contribute a fixed amount each pay period to your account, which is then used to buy shares in one or more mutual funds. Over time, your regular purchases may reduce the average cost you pay for all your shares -- and that can help increase your returns.
You should recognize that dollar-cost averaging doesn't protect you from investment losses. And, certainly, you should consider your financial ability to continue investing in a declining market. A stock can actually decline until it's worthless -- so don't count on dollar-cost averaging to protect you from the damage caused by buying a bad stock.
ShareBuilder is designed to make dollar-cost averaging easy by allowing you to buy in dollar amounts -- or "dollar-based investing". When you buy stocks at a typical brokerage, you can only buy whole shares. If your chosen stock currently sells for $70 a share, and you have $200 to invest each month, then you can only buy two shares for $140 (plus commissions) this month and the remaining $60 has to sit on the sidelines until the next month (which means it can't be working for you in your portfolio).
If you have $50 a month to invest at a typical brokerage, and the stock you've selected currently sells for $85 a share, what do you do? Either you wait until you scrape together the remaining $35 (and hope the price doesn't go higher), or you find another stock.
With ShareBuilder, dollar-based investing means you can purchase fractional shares with the entire amount of your investment dollars. Your $200 will buy you 2.857 shares of your $70 stock (not including transaction fees). Or your $50 will buy you 0.588 shares of your $85 stock, so you don't have to put off investing until tomorrow. And you can easily stay on a dollar-cost averaging plan, investing a fixed amount no matter what the fluctuation in the price of your chosen securities.
Tomorrow:
Mapping Your Route to Investing Success
In our next lesson, you'll learn the basics of building a portfolio. You'll find out how to identify your financial goals, pay yourself first, and build a diversified portfolio.
Further reading:
Estimating Retirement Expenses
Understanding Risk
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Topics This Issue
Balancing Risk and Reward
Investing, Dollar by Dollar
Open a ShareBuilder Account
Key Points
Risk is the likelihood that you'll either lose money or earn a lower return than you expect from any investment. To understand more about risk, see "Understanding Risk".
Inflation is the rising costs of goods and services. Over time, inflation makes a dollar able to buy fewer goods and services than it did in the past. For more on the effects of inflation read "The Impact of Inflation".
Here's a hypothetical example of how dollar-cost averaging can work. If you had invested a lump sum in the Standard & Poor's 500 index at the start of 1929, months before the start of the Great Depression, by 1938 your investment would have lost about one percent a year. That's ten years when your money would have accomplished absolutely nothing for you. However, if you had spread your dollars into equal quarterly investments through the same period, you would have earned 7.4 percent on average each year. Of course, past performance is not a guarantee of future returns. Read more about dollar-cost averaging in our investor education center.
Dollar-based investing has two main advantages since it allows you to buy fractional shares of stocks: you can invest small amounts in order to purchase stocks whose share prices are high, and you can put all of your investment dollars to work when you do make a purchase since you are not limited by share prices.
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©2007 ShareBuilder Corporation. ShareBuilder is a registered trademark of ShareBuilder Corporation. Patent Pending. ShareBuilder Securities Corporation, a registered broker dealer, is a subsidiary of Netstock Corporation and Member NASD/SIPC.
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