Before you spend your hard-earned money on an investment, it's crucial to understand what separates a good investment from a bad investment and to think in terms of your overall portfolio.
In a specific sense, this means choosing investments that match your current and future needs while respecting your risk tolerance. In a broader sense, asset allocation, or the way you divide your investments, helps you reap the rewards of high-risk investments while balancing them out with more stable investments.
Factors to consider before investing in a company
As you pick individual stocks for your portfolio, you’re choosing from thousands of companies to invest in. Predicting which stocks are most likely to provide a return is tricky, though.
When selecting investments, consider both your current and future financial needs.
Before you decide to buy stock in a company, research these important criteria:
- Earnings growth: To understand a company's financial history, look at its earnings growth and compare its long-term growth pattern to market averages. Don't get overly excited about earnings growth, though. While it is an important indicator of possible future financial stability, it can also signal the end of an era of growth for a company.
- Return on equity: ROE indicates a company's ability to produce a profit in relation to shareholders' equity. ROE can provide a snapshot of how a company's success translates to earnings for shareholders when compared to other companies in the sector and the overall market.
- Organizational management and stability: The way a company's leadership manages assets and plans for growth can determine a stock's potential. Likewise, if you’re looking for a long-term investment, organizational stability is a major consideration.
- Debt-to-equity ratio: Companies with only a small amount of debt often generate earnings growth using equity rather than borrowing money to grow the business. The D/E ratio is equal to a company’s total liabilities divided by shareholders' equity. Higher ratios mean that debt is fueling the company, increasing the likelihood of volatile earnings.
- Your portfolio mix: Try to invest in more than one industry and type of business. You could easily see severe losses in your portfolio if you are invested in only one or two industries and they suffer financial setbacks. Likewise, investors with a portfolio full of growth stocks may choose to offset potential losses by also investing in some low-risk assets.
- Business model: Prioritize investing in companies that provide a product or service you understand. It's easier to evaluate companies if their business makes sense to you.
- Volatility: Look through 10 years of earnings to determine whether a company's volatility is a short-term or a long-term problem. Stocks that maintain a more stable price represent less overall risk.
- Competitive advantage: Companies with a unique product or notable brand loyalty may provide the type of competitive advantage that inspires long-term growth. Competitive advantage is generally one of the last things to consider when choosing a stock, though. While it may make a company interesting, a competitive advantage doesn't necessarily mean you'll make money on your investment.
The topics mentioned here are a good starting point for your research, but this type of deep dive into individual companies and stocks can be time-consuming. If you’re interested in outsourcing this research, consider hiring a qualified financial advisor. Remember, there's always a chance that you'll lose money on an investment, though.
What is portfolio diversification?
Portfolio diversification reduces your overall risk of losing money. When you spread your investments across different industries and types of assets, you limit your exposure to the risk of any individual sector.
A diversified portfolio often contains a mix of domestic stocks, international stocks, bonds and short-term investments, but you can also invest in sector funds, real estate funds, commodity-focused funds and asset allocation funds. The goal of diversification is to limit the negative impact of an asset’s volatility on your portfolio, but you can design your portfolio to match your risk tolerance.
For example, if you can't stand the thought of losing money (even in the short term) but want to grow your assets, you may have to accept a lower rate of return in exchange for the safety of bonds. You can still invest in more aggressive assets, like stocks or options, but it's wise to allocate at least half of your portfolio to low-risk investments.
An aggressive investor that doesn't fear short-term losses may choose to invest heavily in foreign stocks. Both foreign and U.S. stocks have a greater chance of fast growth than bonds, but they also have a much greater chance of losing value. If you plan to leave your money in the stock market for many years and are OK with the value of your assets going up and down over time, it may make sense to buy more stocks.
In general, investors with decades to grow their assets may feel that the potential to make money on somewhat volatile investments outweighs the risks. However, those with shorter timelines may not want to put their money into high-risk investments, even if lower-risk investments could limit the growth of their assets.
A diversified portfolio often contains a mix of domestic stocks, international stocks, bonds and short-term investments ... ”
Where to invest money
Deciding where to invest money can seem like a huge undertaking, and it's a project that many Americans never start. In fact, 45% of Americans don't own any stock, including retirement accounts or mutual funds. Between 2001 and 2008, 62% of Americans owned stock, but after the Great Recession, that number fell, according to a Gallup poll.
However, you still have a lot of options for investing. Here are some popular choices to help you reach your investment goals.
- Stocks represent ownership in a corporation that can be bought and sold on stock exchanges. Businesses sell stocks to raise funds, and share owners get a partial claim to the company’s assets and earnings.
- Bonds help corporations and governments raise money. They represent a loan with a fixed interest rate and maturity date. On the bond's maturity date, the issuer pays the bondholder the face value. There's a risk of default and inflation, but in general, bond values fluctuate less than stocks.
- Real estate
- Investing in real estate could mean flipping houses for profit, owning rental properties or buying paper assets. Real estate investment groups (REIGs) allow investors to buy real estate as a group by pooling their assets. Real estate investment trusts (REITs) provide investors with the opportunity to add real estate to their portfolios without owning specific properties.
- Retirement accounts
- There are a few retirement account options:
- 401(k)s, offered through employers as a benefit, allow employees to set aside some of their paychecks. 401(k) contributions and gains aren't taxed until you make withdrawals. Some employers match employees' contributions to their 401(k)s up to a certain percentage.
- Individual retirement accounts (IRAs) work as an alternative to 401(k) plans. Contributions aren't taxed until you make a withdrawal. If you don't have a 401(k) account, you may be able to take IRA contributions as a tax deduction.
- ROTH IRAs don't provide a tax deduction, and contributions to ROTH IRAs are taxed. However, you don’t have to pay taxes on gains in these accounts. Some employers offer Roth 401(k) accounts for employees that want to invest money they've already paid taxes on.
- Simplified Employee Pension (SEP) IRAs are an option for self-employed people with few or no employees. Contributions are tax-deductible, and annual contribution limits are higher than with other types of tax-deductible retirement accounts.
- Index funds
- Index funds are made of bonds or stocks and are designed to follow a market index. Fund managers ensure the fund performs at the same rate of return as the index, and you have hundreds of indexes from which to choose. Some of the most popular indexes of large U.S. stocks include the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite. If you're interested in small U.S. stocks, you may choose the S&P SmallCap 600 or Russell 2000 Index.
Sector indexes tied to a specific industry, country indexes that track certain stocks in a specific place and style indexes that track value-priced stocks or companies poised for fast growth are also popular options.
- High-yield savings accounts
- A high-yield savings account offers a much higher interest rate on your savings than a traditional savings account. High-yield savings accounts provide a relatively safe place to keep emergency savings or cash you may need to access quickly. While your savings may lose money due to inflation in a regular savings account, a high-yield account may keep up with inflation better, depending on market conditions.
Your bank may require a large deposit to open a high-yield savings account, though, and you may have to maintain that balance or pay fees to keep the account open.
- Article source
- ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. To learn more about the content on our site, visit our FAQ page.
- Gallup, “"What Percentage of Americans Owns Stock?”” Accessed May 15, 2021
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