12/31/2024
Day 2/10: Foundation
Today, we cover foundational investing concepts to set you up for wealth-building success. You will:
Document and validate your investing goal
Learn about the relationship between risk and reward
Evaluate your risk tolerance
Understand how diversification and asset allocation help you manage risk
Identify where you are in the investing lifecycle
Ready to get started? Let’s dive in.
Your Goals Shape Your Investing Plan
Why do you want to invest? Having a clear, concise answer to that question empowers you to make consistent and appropriate investing decisions.
The type of investing you do to fund retirement will be different from, say, how you’d invest to buy a home in 10 years. That’s why you need a clear goal from the start.
What’s your reason? Write it down now and include as much detail as possible. Examples of a solid investing goal statements are:
Amass $2 million in my retirement account by 2055.
Accumulate $200,000 in my child’s college fund by 2033.
Validating Your Expectations
With your investing goal documented, it’s time for a quick reality check. Use a savings goal calculator like this one to estimate the monthly investment required to meet your goal.
Any investment calculator will prompt you for an estimated interest rate. For context, the long-term average annual return of the stock market adjusted for inflation is about 7%. You could use a slightly higher interest rate if you plan to invest more aggressively, or a lower one if you prefer a more conservative approach.
Risk and Reward
Know that aggressive investing produces more volatility and less certain results. This is an important consideration. The 10-year bull market that ended in 2021 lured many investors into believing in gains without consequence—but there is always a trade-off between safety and expected return. To raise your potential return, you must assume more risk. To minimize volatility, you must invest more conservatively.
Your Comfort Zone: Understanding Your Risk Tolerance
Review the scenarios below and consider how you might react to each one:
The stock market crashes and your portfolio value drops from $200,000 to $150,000 in one week.
You buy a stock for $100. Six months later, that stock is trading for $50.
Your portfolio value swings up and down weekly or monthly, by as much as 10%.
Your reaction in these situations will range from panic to patience. If your heart rate ticked up while thinking through these scenarios, you are risk-averse. On the other hand, if you see these situations as temporary conditions that you can wait out, you are risk-tolerant.
YOUR INVESTING TIMELINE
Having the ability to wait out negative market conditions allows you to invest more aggressively. Here’s why. The frequency of market downturns declines significantly over longer timelines. In history, there have been many downmarkets that have lasted less than one year. A market downturn that lasts five years, though, is less common. Even more interesting: The stock market has never lost value over 20 years or more.
This is why it’s important to understand your investing timeline. A longer timeline is always safer.
What you want to avoid is having to sell your stocks in the midst of a downturn. That locks in losses and undermines your long-term returns.
Return to your investing goal statement now and verify that you’ve documented a timeline. To protect yourself from having to sell when stock prices are down, your timeline should be at least five years for stock investing. If it’s shorter, consider fixed-income or cash investing instead.
Risk Management: Diversification
Diversification is the practice of holding different types of investments. You can diversify across asset classes—as in stocks vs. bonds—or within asset classes. To diversify within the stock asset class, for example, you’d hold companies that represent different industries, geographies and market capitalizations.
Diversification ensures that your assets aren’t exposed to the same risks. The goal is to avoid the situation where all your holdings are losing value at the same time.
Many investors learned a tough diversification lesson recently. After a period of strength, the biggest technology stocks struggled between November 2021 and December 2023. The tech-heavy Nasdaq Composite dipped more than 30% in that timeframe.
Investors who’d doubled down on Meta, Alphabet and Amazon felt the full force of that industry-specific downturn. Those who held a more diverse portfolio weren’t hit as hard.
Proper diversification minimizes risk and maximizes return. As a general rule, aim to hold about 20 individual stocks with different risk profiles.
Investing
