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by Douglas Gerlach
What do you do before you get into your car and drive to a destination you've never visited before? Unless you have one of those newfangled GPS devices, you probably consult a map. A map can show you various ways to reach your destination - the most scenic route, the route with the least amount of traffic, or the most direct route.
Investing is a lot like driving. You need to set your financial goals, and then you need to create a plan to achieve them - your map. If you don't have goals, how will you ever know if you've arrived? And without a financial plan, you risk getting lost along the way and never meeting your objectives.
Identify Your Goals
So what are your financial goals? Here's a tip: "making a lot of money fast" is not necessarily a reasonable goal. When you think of your goals, you should think about your hopes and dreams, for yourself and your family. What do you hope to achieve in life? Possibly buy a home and send your children to college? Or maybe you'd like to retire early and travel the world? Financial professionals often counsel investors to write down their goals. Their intention is not to make you ponder the meaning of life, but to help you create the best plan to reach those goals along the way.
There's another benefit that comes from identifying your goals. Saving and investing just for the sake of getting rich might work for some people. For others, though, giving up $50 a week can put a strain on their wallets - until they look at a photo of their children and remember that the $50 they're investing now will go toward helping pay their kids' college tuitions later. Keeping your goals in mind -- whether it's that dream house in the mountains, early retirement, getting out of debt, or quitting your job to start your own business -- can make the task of reaching those goals much easier.
Pay Yourself First
After you identify your goals and how much you need to reach them, you should begin setting aside money on a regular basis to invest in your plan. Saving on a regular basis is key to reaching your goals, no matter how little the amount you start out investing. Don't be discouraged if your goal seems large and unreachable. Remember that even a leaky faucet can fill your sink with water, drop by drop. Making investments on a regular basis, even if you can only set aside a small amount each month, can eventually build a sizable portfolio.
Many people think that they can't spare any cash to start an investing plan. These people probably have not learned the importance of paying yourself first. Setting aside a small amount for your long-term investing plan each week or each month before you pay any other bills or expenses is all you have to do. But there's an even easier way to make sure you pay yourself first each month. ShareBuilder will let you set up automatic transfers from your checking or savings account. Each month, the amount you specify will be moved from your bank to your ShareBuilder Account so it can be invested in the stocks you chose.
Before You Build
Before you start buying stocks or other securities, you should understand how all those investments work together in a single portfolio. There's more to building a portfolio than simply buying a bunch of stocks. The good news is that there are some easy portfolio management principles you can use to help you reach the potential for maximum reward from your investments while minimizing risk.
The Importance of Diversification
One of the basic principles of portfolio building is diversification. As the old saying goes, "Don't put all your eggs in one basket." You can reduce the risk of investing over the long term by spreading out your investments. For instance, if you invest in an umbrella company, you'll do fine during the rainy season, but what happens when the sun shines? If you also invest in a company that makes suntan lotion, then part of your portfolio can do well during both rainy and sunny times.
You can diversify your portfolio by choosing different types of investments - such as stocks or bonds (known as asset classes) - or by investing in different securities within one of those categories - such as buying stocks that are involved in different businesses.
Setting Your Asset Allocation
One way that investors diversify their portfolios is by placing a certain percentage in different types of investments, such as stocks, bonds, cash, real estate, or gold. These are all examples of asset classes: broad groups of investments that tend to perform in the same general way during similar economic conditions. Certain asset classes will tend to perform in opposite ways from other asset classes, given the same circumstances.
For instance, bonds tend to perform well when stocks don't, and vice versa. If you own a mix of both stocks and bonds, the value of your overall portfolio may not bounce around quite as much as if you owned all stocks or all bonds. When you spread out your investments among different asset classes, you can generally reduce the swing in value of your overall portfolio.
So how much should you in invest in different asset classes? The process of dividing up your portfolio into different asset classes is known as "asset allocation." In order to determine the best asset allocation for your portfolio, you should consider your risk tolerance and your goals. Often financial advisors will create model asset-allocation plans for investors with recommended percentages to invest in various asset classes.
Build a Diversified Portfolio of Stocks
Investing in individual stocks allows you to put your money exactly where you want to, in the stocks you've identified as having the best opportunities for making a profit. But diversification is even more important when you invest directly in stocks. If you invest in a single stock, your return depends solely on that security. If the stock does well, your portfolio will prosper. If that security flops, your portfolio will as well. Likewise, if you invest solely in companies in the same industry, such as technology, your portfolio would suffer in the event of a major downturn in that industry.
When you build a diversified portfolio of stocks, you should aim to include stocks from different industries. (You might choose stocks from a computer maker, a heavy-equipment manufacturer, a pharmaceutical company, and a restaurant chain.) By spreading out your investments this way, you can minimize the impact of any problems affecting a particular sector of the economy.
Another way to diversify your portfolio is by company size. You might want to invest in small companies that are growing rapidly, mid-sized companies that are growing moderately, and large companies that are growing slowly but surely. This strategy can help decrease risk, since you won't be concentrated in either the riskier "small-cap" stocks or the more stalwart blue chip companies.
Tomorrow:
Stocks: The Basics
Learn the basics of investing in stocks. Find out how the stock market works, how a stock's price is set (and why it changes), and learn the advantages of investing in stocks over time.
Further reading:
Diversification
Setting Goals and Staying on Course
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Topics This Issue
Identifying Your Goals
Learning to Pay Yourself First
Building a Diversified Portfolio
Open a ShareBuilder Account
Key Points
Identifying your financial goals will motivate you to work toward reaching those goals, as well as allow you to create the best plan to meet them. For more on goals, check out "Setting Goals and Staying on Course".
Paying yourself first helps you to slowly build up your investment portfolio on a regular basis, especially when combined with an automatic money transfer from your bank account.
Diversification is the holding of securities from different asset classes or industry groups in an effort to reduce risks. Learn more about how it works in this article: "Diversification: What It Is and Why You Need It".
An asset class is a broad category of investments, such as stocks, bonds, real estate, precious metals, or cash.
Asset allocation is the assignment of your investment dollars to different asset classes in an effort to reduce the risk of your overall portfolio.
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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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