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Financial Planning Guide for 2012: Ten Timeless Investment Facts & Principles

1-6-12

By NJToday Contributor Barbara O’Neill

Just like “classic” fashion designs, there are some investment facts and principles that never go out of style. This is true whether the stock market is going up or down, tax laws are changing, or investment returns are high, low, or negative. In other words, these facts and principles can be counted on to inform investors’ decisions at any point in time. Consider the following ten timeless investment facts and principles:

1. With increased investment risk comes the potential (but not the guarantee) of higher returns. The following investments are ranked in order of their risk from lowest to highest: Treasury bills (short-term U.S. government debt), long-term government bonds, corporate bonds, large company stocks and stock funds, small company stocks and stock funds, and international stocks and stock funds.

2. Investments should match the time frame of financial goals. For short-term goals, consider money market mutual funds, short-term certificates of deposit (CDs), and Treasury bills. For long-term goals that are more than five years away, consider common stocks and stock mutual funds.

3. Bonds are IOUs (debts) of governments and corporations. They pay periodic interest, typically twice a year, and return an investor’s principal at maturity. The longer the time to a bond’s maturity, the higher the interest rate generally demanded by borrowers because there is more market risk associated with holding it. This is known as an “ascending yield curve.” When the yield and time to maturity are plotted on a graph, the yield rises as the holding period increases. Flat and inverted yield curves are also possible.

4. Common stock provides investors with an ownership interest in a company. As part owners, investors share in a company’s earnings (profits) and losses. Stock investors make money from dividends and capital gains when shares are sold for a higher amount than the original purchase price.

5. Derivatives are investments whose price is dependent upon, or derived from, one or more underlying assets. An example is options to buy or sell a stock at a set price for a certain period of time.

6. Saving is the act of putting money aside for a “rainy day” (i.e., unforeseen emergencies) and short-term financial goals. Investing is the act of purchasing securities to make your money grow over the long-term. Generally, investments should not be purchased for financial goals that are less than five years away.

7. A frequently used investment strategy is dollar-cost averaging. This means investing a regular amount at a regular time interval (e.g., $100 each month to buy mutual fund shares). Another example is having 5% of your pay placed in an employer 401(k) account every pay day. Over time, dollar-cost averaging may be able to lower the average cost of an investment but it does not guarantee a profit or protect against losses in declining markets. When market prices are lower, investors buy more shares for their fixed deposit amount (e.g., $100) and, when market prices are higher, they’ll buy fewer shares. For example, a $100 deposit would buy 20 mutual fund shares at $5 per share and only 10 shares at $10 per share.

8. Compounding means that earnings on savings and investments are added to the original deposit amount (principal) to create a larger base on which future interest is paid (i.e., earning interest on interest).

9. Interest from tax-free municipal bonds is generally exempt from federal income taxes. This is due to the principal of “reciprocal immunity” where states don’t tax federal government debts (e.g., U.S. savings bonds) and the federal government doesn’t tax state and local debts (e.g., municipal bonds).

10. Asset allocation is the process of dividing an investment portfolio among various asset classes and, ideally, balancing the portfolio periodically to maintain asset class weights. An example is 50% stock, 30% bonds, and 20% cash equivalent assets. Asset allocation is determined by individual factors such as an investor’s financial goals, age, investment experience, and risk tolerance.

Dr. Barbara O’Neill is an Extension Specialist in Financial Resource Management at Rutgers Cooperative Extension. O’Neill is also a member of the New Jersey Coalition for Financial Education

Next Week: Financial Planning Metrics: How Do You Measure Up?