According to the 2015 EBRI Retirement Confidence Survey, 57% of American workers report that the total value of their household’s savings and investments is less than $25,000, including 28% who have saved less than $1,000. One of the primary reasons (other than lack of extra funds) is that this topic — and all the confusing lingo associated with it — is so intimidating.
Our new Investment Basics series is designed to cover some of the basic principles, products, strategies, and vocabulary needed to make smarter, more informed investment decisions. In this issue, you’ll master some of the critical strategic terminology used in the world of investing.
- Time & Goals — Every investment decision is (or should be) based on these factors: (1) when you’ll need the money (time), and (2) the purpose of the investment (your goals). Evaluating these two points will help you and your advisor make smarter decision
Example: Kaylee is 40 years from retirement, so her investment decisions will be very different from Randy, who is three years from his retirement age. You’ll learn how investment strategies will shift and change based on your time frame and goals in the next issue in this series.
- Auto-Enrollment — As gov explains, employees can benefit from having funds automatically deducted from their paycheck and invested in their retirement plan at work. Most plans allow employees to “opt out,” but why would you want to? This is an easy way to begin saving for retirement, and with the tax benefits of your contributions, you’ll hardly miss the money.
- Auto-Escalation — This popular tactic overcomes inertia to boost savings by automatically increasing the percentage contributed each As reported in this article by Society for Human Resource Management (SHRM), 55% of plan participants favor this strategy. Since most auto-enrollment plans begin with employees investing 2%-3% of their wages — which will not be enough to retire on — bumping the percentage each year by 2% or 3% can help boost your retirement savings significantly.
- Rule of 72 — This is a simple formula developed by Albert Einstein: Divide 72 by the average interest rate you’re earning to arrive at the number of years it will take to double your The differences can be amazing! Example: Joseph earns an average of 2.5% on his conservative investments, but Caroline earns 8% by investing a little more aggressively. It will take nearly 29 years for Joseph’s money to double, while Caroline’s money will double every nine years…or three times faster than Joseph’s! See more benefits of this magic formula in “Your Greatest Asset to Increase Wealth” [PDF] issue.
- Portfolio — The collection of all your invest
- Diversification — This simply means spreading your risk over multiple investment As we’ll cover in the next issue in this series, mutual funds — the options available in most workplace retirement accounts — already accomplish this objective for you. Caution: Diversification will not guarantee a profit or protect against loss if the investor sells when the market is down.
- Asset Allocation — Selecting a mix of different investment types is how we diversify. Each asset tends to move in a different pattern based on specific market factors such as varying interest rates or supply and d For example, some investments may gain under certain conditions, while others may remain stagnant or decline. As a result, holding a variety of assets can help smooth out a portfolio’s peaks and valleys. Look for examples in the next issue in this series.
- Rebalancing — This is the practice of reviewing and updating investments and asset allocation periodically to ensure you’re on track to accomplish your goals within the targeted time Discuss options with your advisor.
- Dollar Cost Averaging (DCA) — With DCA, you don’t have to worry about trying to “time” the market. Simply invest every pay period, whether the market is up or This is what most employees are already doing by participating in their plan at work.
This chart illustrates a simplistic example of how DCA works in a volatile market, as the price per share rises and falls throughout the year. If we invest $1,000 each quarter, or a total annual investment of $4,000 during the year, we’d purchase a total of 100 shares by the end of the year at an average cost of $40/share ($4,000/100 shares).
DCA works because when the market drops (like in the 3rd quarter below), we’re able to purchase more shares. Then, when the market rebounds, we have additional shares, which lowers our average price per share.
For example, if we sell the shares when they’re worth $50/share, we’ll generate a profit of $1,000 ($50 x 100 shares = $5,000, minus the initial $4,000 we invested to purchase the shares)…or a 25% return on our investment!
If the value bounces back to 1st quarter pricing of $100/share, our profit will be $6,000 ($100 x 100 shares = $10,000, minus the original $4,000 invested)!
The key to effectively using this powerful strategy is not to obsess about the swings in the market…just keep focused and invest for the long term!
- Volatility — As the chart to the right illustrates, if we look at the past 75 years at various time frames, we can see how volatile the market has be
Historically, over any single year, there have been enormous gains and huge losses. However, when we look at any five-year time period, the gains were more subdued, but the losses were also much less! And, during any 10-year time period, while the gains were lower, the losses weren’t significant enough to fall below zero.
So what’s the REAL risk with volatility? Not giving your investments the time they need to ride out the fluctuations in the market.
- Risk — As we’ve already covered, there is always going to be volatility in the market. It’s continually in flux, which means it will rise, experience a “correction” — or drop — and then typically rebound to rise once The biggest risk is not volatility; in fact, using Dollar Cost Averaging, we can actually benefit from fluctuations in the market.
The biggest risk is the fear of loss and the panic that sets in when the market is down. Investors typically react by doing just the opposite of what smart strategists recommend: We tend to buy when the market is up (because everyone else is), and we sell when the market drops.
Understanding the natural fluctuations of the market helps us make more informed decisions and base them on strategic goals rather than market hysteria.
Learning these strategic terms will provide the knowledge and confidence to discuss the best investment options with your advisor, and the peace of mind to stay the course to accomplish your long-term goals. Go to InvestmentTerms.com or NASDAQ: Investing Glossary for more investment terminology. Watch for the next title in the series, “Investment Basics: Popular Product Options.”