Basic Investing Principles
By: Source: AARP.org Date Posted: 2006-04-17 12:41:45.304025-04:00
Five basic principles help guide your investment choices. Following these time-tested investment principles will give you a strong foundation to build financial security. They are:
Keep fees low
Use index funds
Diversify your investments
Rebalance to stay on track
Keep it simple
Keep Fees Low
Fees and expenses reduce your returns over time. That goes for all types of financial products, including mutual funds, individual stocks and bonds, insurance and mortgages.
When it comes to mutual funds, it's important to know the difference between "load" and "no-load" funds. Load funds charge an up-front sales fee whenever you make an investment. No-load funds do not charge an up-front sales fee. If you are evaluating mutual funds, look for no-load funds with expense ratios of less than 1 percent.
Similarly, when it comes to trading individual stocks or bonds, you want to keep costs low. Stock brokers charge a commission every time you trade. If you are interested in purchasing individual stocks and bonds, consider using a discount brokerage firm and completing your trades online when possible to keep your trading costs low.
Here are some examples of how fees can impact your performance:
In the short-term
If you pay $70 in commission to buy 100 shares of a $7 stock, the stock would have to rise 70¢ in price just for you to break even. In other words, every time you pay a fee, you're starting out "behind the starting line." You're in the hole. If, for another example, you pay a 2% annual fee to own a mutual fund, the fund has to earn 2% simply for you to break even.
In the long-term
Even worse—and too few people really understand this—the costs of investing can have a dramatic impact on how much you earn as time goes on. Consider the impact of different fees on a mutual fund:
| What the fees cost you on an initial $10,000 investment | Pay these fees for a low-cost fund (0.50%) | Pay these fees for a mid-cost fund (1.25%) | The low-cost fund saves you… |
| 10 years | $796 | $1,925 | $1,129 |
| 20 years | $2,531 | $5,902 | $3,371 |
| 30 years | $6,034 | $13,585 | $7,551 |
AARP Resources
Learn more about how to find financial products and services with low fees.
Use Index Funds
Index funds are low-cost mutual funds that seek to mirror the performance of the broader markets they represent. Years of investment research show that mutual fund managers who try to buy and sell individual companies based on their own research have a hard time outperforming the broader markets over time. That's why index funds are so attractive.
First, what is an index?
When you hear that the market went up or went down, you're actually hearing about an index, which is a general indicator of price trends in groups of stocks or bonds. An "index" is a group of stocks or bonds that experts believe collectively represent a larger group of stocks or bonds, such as "all small company stocks," or all "stocks on the Nasdaq," or "all high tech stocks."
What are some of the most popular indexes?
What is an index fund?
These are mutual funds that hold all (or a representative sample) of the stocks or bonds that are included in a particular index. The purpose of the fund is to mimic the performance of that index. If the index goes up, your fund makes money; if the index goes down, your fund loses money.
Index funds are often called "passively managed" funds, because no attempt is made to use "active" management strategies or to make "bets" on individual securities. Funds that buy and sell companies based on their individual merits are often called "actively managed."
Why buy index funds?
Index funds offer a broad range of benefits including:
- Simplicity. Index funds take the guesswork out of investing. For example, if you decide to invest in the stocks of large-cap companies, you can simply buy shares of an index fund that mimics that group of stocks.
- Lower costs. Index funds tend to have lower costs than other mutual funds since they are less complicated to operate and require fewer employees to support. And, it's worth repeating, the lower your costs, the more you're able to earn.
- Diversification. Index funds typically hold more securities than actively managed funds, offering the potential for increased diversification. By holding more securities you reduce the risk, because while some of the investments may go down, others may go up.
- Matching the market. With an emphasis on simply matching the performance of the broader markets, index funds typically have strong historical performance versus actively managed funds.
- Tax advantages. Because there is relatively little portfolio turnover in an index fund, there is less potential for the capital gains than you might find in an actively managed fund that frequently buys and sells different securities.
Additional Resources
Diversify to Reduce Risk
The old saying about "not putting all of your eggs in one basket" is especially true when it comes to investing. Diversification means spreading your investments among different asset classes, such as stocks, bonds and cash equivalents. It also means having exposure to a large number of different companies so that your investment success isn't dependent on a single company or sector of the market.
None of us can tell with certainty which investments will rise in price, but if your investments are diversified enough, you increase your chances of owning investments that rise in value. Just as important, however, diversifying your portfolio helps lessen the impact of investments that lose value. In short, diversification is a way to help reduce risk in your overall portfolio and improve your returns over time.
Mutual funds can be a convenient and effective way to achieve instant diversification through a single investment. Be careful though. Some people invest in several mutual funds that all have similar stocks in them. They think they're diversifying across several mutual funds, but instead they're duplicating efforts.
Rebalance to Stay on Track
Once we have made our investment decisions, we often forget to revisit them. But markets change. Rebalancing helps you maintain your target asset allocation among stocks, bonds and cash. If the value of the stocks in your portfolio increases, the ratio of stocks to bonds could change. Over time, you could end up with more risk than you realize. Rebalancing refers to adjusting your assets periodically to meet your target allocation of stocks, bonds and cash.
For example, let's say that you've decided you want 60% of your money in stocks, 35% in bonds, and 5% in a money market fund in order to save for a comfortable retirement. This gives you plenty of potential growth, a good amount of lower-risk bonds that will produce income but balance out some of the risk in the stocks, while allowing you to keep a small portion of your money anchored in a very safe, very low-income money market fund.
Six months later, the stock market has zoomed. When you check on the percentages, you see that your stocks have increased in price so much that now they make up 70% of your money and bonds are now only 25%. You're now "out of balance." So, happily, you sell some of the stocks; then you take those profits and buy more bonds. The goal is to get back to 60% stocks and 35% bonds. Now you're back on track with the both the aggressiveness and the safety you want.
Some funds are regularly rebalanced to help them maintain their diversification and control risk in the portfolios.
Rebalance if life goals change
Another reason to rebalance has to do with your life and the world around you. Goals change. Economic factors change. That's why it's important to review your asset allocation once or twice a year and adjust them to keep your investments in line with your needs and expectations.
"Buy low, sell high" is one of the cornerstones of successful investing. Rebalancing forces you to sell investments that have gone up in value and look for new opportunities elsewhere. You're locking in profits, instead of being tempted to try to squeeze out a little more profit by holding those investments longer.
Keep it Simple
There are over 10,000 mutual funds in the United States. So which ones are right for you? How do you find out? And how can you be confident that you've made the right decisions?
Having too many choices can be overwhelming, making it difficult to manage risk, ensure proper diversification and be confident that all of your investments are working toward a common goal. Tracking the progress of many investments takes time, not to mention the paperwork.
Owning a few simple, well-chosen investments is a sound approach for many investors. For example, the average investor today doesn't need complicated investments, such as futures, options and hedge funds. If you don't understand an investment, then don't buy it.
Life can be complicated enough without including the world of investments. So keep it simple. Look for solid mutual funds. Simple mutual funds such as index funds often can do the trick. Also consider lifestyle or retirement date funds that are geared to a specific age group and gradually become more conservative as retirement age approaches.
Additional Resources
Read about the cautions of owning too many mutual funds.
Learn more from the AARP series Money Matters.
Additional Related Links
Allocating Your Money to Meet Your Goals
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