An investment is the purchase of something with the expectation that its value will increase over time. Some people purchase antiques, some purchase art, some purchase precious metals, some purchase real estate, and so on.
The two most common investment purchases are stocks (your ownership stake in a company), and bonds (the money you lend a company). How much you put into stocks and how much you put into bonds is your "asset allocation." You want the asset allocation to fit your time horizon and your risk tolerance.
In the long run, stocks provide a higher return. But they carry the possibility of greater loss. Bonds provide a lower return but tend to counterbalance the volatility of stocks. When you mix bonds with stocks your portfolio value will be more stable.
This Investment section analyzes the implications of a portfolio comprised primarily of widely diversified, low-cost, stocks and bonds. It's easy to implement and provides quite a suitable return. It may help to explain my investment strategy with a story told by William Bernstein: "The market is like an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog's owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he's heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner."
I do my best to ignore the dog and keep my eye on the owner. So I am not a stock-picker, nor a segment picker. Instead, I invest in low-cost mutual funds, periodically rebalanced to an asset allocation suitable for my risk tolerance. This provides a good return and is easy to implement. If this is interesting to you, read on...
Suppose in 1990 you were 25 years old, and you expected to live to age 85. (Just suppose!) So you took a very long view of your investments. You put 80% of your allocation in stocks (and 20% in bonds) and every year you adjusted your portfolio to keep your asset allocation near that 80/20 split. In 2010 you were still alive and decided to compute your average annual return over those 20 years. You discovered that your portfolio grew at an average annual return of 10%/year! So you celebrated! Just out of curiosity, you took a look at your year-by-year returns and noticed that along the way your portfolio went through a LOT of fluctuations! One year you lost 30%! There was a 3 consecutive year stretch when you lost a cumulative 14%! Fortunately, you were young and had a high risk tolerance, and stayed with the strategy. So now you are quite happy with your return. And you should be.
Now let's pretend something quite different. Suppose that in 1990 you were already 65 years old. So you couldn't plan on living for another long period of time. So you made a more conservative asset allocation to only 20% stocks (and 80% bonds) and each year you adjusted your holdings to keep near that split. Fortunately, you were still alive in 2010 (and still able to do the math) so you calculated your average annual return over those 20 years. It comes out to 6%/year! That's pretty good but not as high as the previous example. And that 4% difference compounded over 20 years does add up! But like your younger friend in the previous paragraph, you checked on your year-to-year fluctuations to see if your more conservative asset allocation did indeed buffer you from some of the volatile years. You were delighted to find that your worst single year was a loss of only 3.5%. When you searched for your worst 3-year cumulative loss you discovered that there never was such a 3-year stretch when you lost money! Indeed, the worse cumulative 3-year stretch you saw was a 9% gain! This makes you even happier! And it should.
You may wonder where these numbers came from. They are from Daniel Solin's book The Smartest Portfolio You'll Ever Own. I sincerely hope you will check out Daniel's website. (Nope, I have no "affiliate" relationship with either Daniel Solin or Amazon. So I don't get any cut from your purchase.)
To learn more about investing, browse the Subpage listing at the upper right of this web page... and start reading. Whenever you are unsure of a term, check the Glossary.
All the best, Tim Isbell