Want to be rich? Then you need to learn how to build wealth by making your money work for you. When you become an investor, you seek to acquire things that offer the potential for profitable returns. Whether it be stocks and bonds, retirement accounts, or mutual funds, both time and discipline are necessary to build a solid foundation for your personal finances. It’s important to keep in mind that every investment strategy will vary depending on your risk tolerance and objective(s).
Understanding Risk vs Reward
When it comes to investing and building wealth, there will always be some level of risk/reward tradeoff involved. Risk can never be eliminated but it can be significantly reduced. Longer-term investments such as retirement accounts, are generally less risky and yield smaller returns. If you’re looking for a big payout in a short period of time, you will have to accept a disproportionally higher level of risk.
The question you must ask yourself is, “How much am I willing to risk?”
What do you invest in?
A properly diversified investment portfolio should include:
- Cash
- Exchange-traded Funds
- Mutual Funds
- Stocks
- Bonds
The most important factors when it comes to successful investing depend on two things:
Proper Asset Allocation - The combination of bonds, stocks, and cash in your portfolio should be a diverse mix of low-cost mutual funds and ETFs while holding up to 10 percent of your assets in individual stocks.
A general rule of investment strategy is to diversify your portfolio. Diversification is a management strategy that blends together different investments into a single portfolio. The idea behind diversification is that a variety of investments will yield a higher return and suggests that investors will face lower risk by investing in different vehicles.
Planning and Executing Your Investment Strategy - Create an automatic investment plan and stay with it! Avoid making emotionally charged decisions such as selling at the bottom of a market crash.
Types of Investments
ETF - An exchange-traded fund (ETF) is an investment fund traded on stock exchanges. An ETF is made up of a number of stocks, commodities, or bonds.
Mutual Funds - A type of professionally managed investment that pools your money together with other investors to purchase a collection of stocks, bonds, money market instruments, and other securities that might be otherwise difficult to recreate on your own.
Mutual funds and exchange-traded funds are both pooled investments which bundle together securities to offer investors the benefit of a diversified portfolio. Mutual funds and ETFs can have anywhere from 100 to 3,000 different securities within a fund. The one that works better for you will depend on your investment strategy.
Individual stocks - If you’re just starting, don’t invest more than 10% of your portfolio into individual stocks. Learn as much as you can about value investing and the “buy-and-hold” mentality. Once you know what you’re doing, the stock market can be one of the best places to grow your money.
Bonds - Bonds are a form of debt where you serve as the bank. When you buy a bond, you are actually loaning your money to a corporation, a city, or a government to fund their projects. In return, they will repay you the principal investment on a bond graduation date which is also known as the maturity date. And in the interim, they will make biannual interest payments on the loan. As a rule of thumb, bonds are safer than stocks but less profitable. While no investment is risk-free, government bonds (T-Bonds) are just about as close as you can get.
Retirement Accounts
Traditional IRA - An individual retirement account (IRA) is a tax-advantaged investing tool used to set aside funds for retirement. Investments held in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds. IRA’s are great investments because you get a tax deduction on your contribution and you’ll most likely be in a lower tax bracket when you retire which means you’ll be paying fewer taxes on this income. In addition to that, your earnings will grow tax-deferred until they’re withdrawn.
Roth IRA - Roth IRAs are always funded with after-tax dollars and is one of the best retirement accounts available. A Roth IRA provides investors the chance to invest money after taxes and then take the contributions and earnings out tax-free.
401(k) - A 401(k) plan is a qualified employer-sponsored retirement plan where eligible employees may make tax-deferred contributions from their salary on a post-tax and/or pretax basis. Some employers will fund your 401(k) account dollar for dollar by matching any contributions you make yourself up to $6,000. If this is the case, it’s advised that you maximize your 401(k) contributions, unless you don’t like free money.
Bottom-line advice
Whether you’ll be managing the money yourself or working with an advisor, you’ll want to start off with a small initial investment in a professionally managed fund. Build a strategy around your savings goals and decide how many years you plan to let that money grow. Make sure to diversify your portfolio so you can minimize the risks and maximize the potential for profitable returns. With a little patience and the right attitude, you will be well on your way to building a solid foundation for your personal finances.