Investing Basics

I have been searching around the internet for some good articles on investment basics. Imagine my surprise when I came across an article from the SEC (yes, the government agency) that was pretty good. In fact, it covers all the key points in just a few pages in plain easy to read words. Today is a good day as I see that some of my tax dollars are going to good use!

I would encourage anyone interested in investing to start with this article. http://www.sec.gov/investor/pubs/assetallocation.htm. My cliff notes version and comments from the peanut gallery are below:

Key Factors – the two key factors to consider when investing are what is referred to as the investment time horizon and the investors risk tolerance.

• Time Horizon – how long you plan to invest. In general a longer time horizon means an investor can have a riskier more volatile investment portfolio.


• Risk Tolerance –the investors ability and willingness to take losses on his portfolio is an important factor that should be identified prior to investing. Risk and reward are inextricably entwined. If you want higher returns, you need to recognize that you will need to accept higher risks (read losses)

Investment Choices – there are three broad classes of assets that are typically considered part of an investment portfolio – stocks, bonds, and cash. In addition there are other category specific investments (such as real estate) that might also be included in a portfolio. In my opinion these other categories should only be invested in after the investor has meaningful investments in the three major classes. I know many of you are wondering why I think this way because real estate is (or was) all the rage these last several years. I will write another post later on the appropriate place for real estate in your portfolio.

• Stocks – highest returns and highest risk. There are subclasses within the stock category, with varying degrees of risk. The broadest of these subclasses are U.S. large cap, U.S. mid cap, U.S small cap and foreign stocks.


• Bonds – bonds are generally less volatile than stocks and thus offer lower returns. Bonds are highly influenced by interest rates so their value will vary with movements in the rates (which is why bond traders pay close attention to the Fed). Subclasses of bonds include government bonds (lowest risk), corporate bonds (with risk related to the issuers credit rating) and foreign bonds (which have the added risk of foreign currency)


• Cash – the safest of the asset class but also the lowest returns. Cash portfolios are not likely to outperform inflation over long periods of time.


• Other – this class includes (real estate, precious metals and other commodities, and private equity. In my opinion, these asset classes should not represent a significant portion of a beginning investors portfolio (except of course the real estate that you plan to live in)

The initial decision that an investor needs to make is determining which asset classes to invest in. This is called “Asset Allocation” and will be determined largely based on the investors time horizon and risk tolerance. The SEC sites has a link to an asset allocation calculator offered by the Iowa Public Employees Retirement System. http://www.ipers.org/sub/calcs/AssetAllocator.html Imagine that, another good product from a government institution. Try it. I think you will find it useful.

The SEC article introduces two other important investment concepts – diversification (which I talked about in yesterday’s post) and rebalancing (maintaining the appropriate asset allocation).