Last week, I wrote about the "why" and "what" of investing: To create wealth over the long term by using bond and equity exposure to get there. But that still leaves the big question: How do I invest? This is tougher, especially now when the markets are in turmoil.
It's these chaotic times when the basics are more important than ever. Here's a quick review, whether you're a veteran of many market cycles or a beginner:
-- Plan: Start by articulating your financial goals and dreams by putting a time frame on each. You might say, for example, "I want to save for college for my 3-year-old daughter." What does that indicate in investment terms? Well, it means you have 15 years to amass a certain amount of money. And you can probably figure out how much college, public or private, is likely to cost 15 years from now. That's the basis for an investment strategy.
Retirement is another obvious goal that requires planning. There are various tools on the Web to help figure out what you're going to need when it's time to leave the work force.
-- Understand your risk tolerance: Now you have to decide how much chance you can take. Many people are highly risk averse when they start investing. The thought of a market decline can be disconcerting. Fear can cause some people to adjust their portfolios -- "I'm moving out of stocks until the dust settles" -- that may seem prudent in the short term but risky in the long term. Similarly, terrific bull markets often cause investors to take more chance than needed.
As you gain more experience with the normal ups and downs of the markets, you'll understand the importance of staying the course and taking the long-term view. Remember, you're investing for a decade (if not two or three) from now, so what happens over the next quarter or even the next year probably won't have any meaningful consequences for you. Risk is opportunity; therefore, don't be afraid to take calculated chances with long-term money -- that's the way you build wealth.
-- Asset allocation: When you create a portfolio, you'll most likely be choosing a mix of the major "asset classes": equity, bonds and cash. Some investment professionals consider international equity as a separate asset class. This is your asset allocation, and it's probably the most important decision you'll make about your financial future.