At a glance
- Expect highs (and lows): The price of an investment can fluctuate, affecting how much the shares you own are worth at any point in time.
- Investing—and taking some risk—gives your money an opportunity to grow so it can maintain purchasing power over time.
- Your asset mix plays a big role in how much risk you’re exposed to and how your portfolio performs over time.
Weighing pros and cons and making decisions based on current information is part of life, and it’s part of investing too. The information below can help you understand investing so you can confidently build a portfolio centered on your goals.
Understand investment basics:
>>Step 1—Understanding risk and return
Step 2—Choosing the right asset mix
Step 3—Saving for retirement
Step 4—Opening a nonretirement account
Step 5—Investing in a stock, bond, ETF, or mutual fund
Prices go up … and prices go down
When you invest, you buy shares of an investment product, such as a mutual fund or an exchange-traded fund (ETF). The shares you own can increase or decrease in value over time. Some of the things that can affect an investment’s price include supply and demand, economic policy, interest rate, and inflation and deflation.
If the shares you own go up in price over time, your investment has appreciated. But it could go either way; there’s no guarantee.
For example, say you invest $500 in a mutual fund this year. At the time of your purchase, the price per share of the fund was $25, so your $500 investment bought you 20 shares.
Next year, if the price per share of the fund increases to $30, your 20 shares will be worth $600. The following year, if the price per share of the fund goes down to $20, your 20 shares will be worth $400.
Did you know?
Mutual funds and ETFs are investment products sold by the share.
A mutual fund invests in a variety of underlying securities, and the price per share is established once a day at market close (4 p.m., Eastern time) on business days.
An ETF contains a collection of stocks or bonds, and the price per share changes throughout the day. ETFs are traded on a major stock exchange, like the New York Stock Exchange or Nasdaq.
Why take the risk?
You’ve probably seen this disclosure before: All investing is subject to risk, including the possible loss of the money you invest. So why invest if it means you could lose money?
When you invest, you’re taking a chance: The value of your investment could go down. But you’re also getting an opportunity: The value of your investment could go up. Taking some risk when you invest gives your money the potential to grow. If your investment increases in value faster than the price of goods and services increase over time (a.k.a., inflation), your money retains purchasing power.
Say you made a onetime investment of $1,000 and didn’t touch it for 10 years. During this time, the average annual rate of inflation was 3%. As a result, your original $1,000 investment would have to grow to at least $1,344 to maintain the purchasing power it had in 2005.
- In Scenario 1, say you invest in a low-risk money market fund with a 2% 10-year average annual return.* Your investment grows by $219, so you have $1,219. Your $1,219 will buy less in 2015 than your original $1,000 investment would’ve bought in 2005.
- In Scenario 2, let’s assume you invest in a moderate-risk bond fund with a 5% 10-year average annual return.* Your investment grows by $629, so you have $1,629. After adjusting for inflation, you have $285 more dollars to spend in 2015 than you started with in 2005.
- In Scenario 3, say you invest in a higher-risk stock fund with a 10% 10-year average annual return.* Your investment grows by $1,594, so you have $2,594. After adjusting for inflation, you have $1,250 more dollars to spend in 2015 than you started with in 2005.
An “average annual return” includes changes in share price and reinvestment of dividends and capital gains. Funds distribute both dividends and capital gains to shareholders. A dividend is a distribution of a fund’s profits, and a capital gain is a distribution of income from sales of shares within the fund.
Depending on the timing and amount of your purchases and withdrawals (including whether you reinvest dividends and capital gains), your personal investment performance can differ from a fund’s average annual return.
If you don’t withdraw the income your investment distributes, you’re reinvesting it. Reinvested dividends and capital gains generate their own dividends and capital gains—a phenomenon known as compounding.
How much risk should you take?
The more risk you take, the more return you’ll potentially receive. The less risk you take, the less return you’ll potentially receive. But that doesn’t mean you should throw caution to the wind in pursuit of a profit. It simply means risk is a powerful force that can affect your investment outcome, so keep it in mind as you build a portfolio.
Work toward the right target
Your asset allocation is the mix of stocks, bonds, and cash in your portfolio. It drives your investment performance (i.e., your returns) more than anything else—even more than the individual investments you own. Because your asset allocation plays a big role in your risk exposure and investment performance, choosing the right target asset allocation is key to building a portfolio centered on your goals.
Check out our next article to learn more about choosing a target asset mix.
*This is a hypothetical scenario for illustrative purposes only. The average annual return does not reflect actual investment results.
All investing is subject to risk, including the possible loss of the money you invest.