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A successful investor maximizes gain and minimizes loss. Though there can be no guarantee that any investment strategy will be successful and all investing involves risk, including the possible loss of principal, here are three basic principles that may help you invest more successfully.
It's the “rolling snowball” effect. Put simply, compounding pays you interest on your reinvested earnings. The longer you leave your money in an account working for you, the more exciting the numbers get.
Two investments to consider are Individual Retirement Accounts and qualified retirement plans. With these, you pay no taxes through the years, so all your money stays invested and earns compound interest. That’s why many experts recommend fully funding all tax-advantaged retirement accounts and plans available to you.
While you should review your portfolio on a regular basis, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don't have to go for investment “home runs” to be successful.
Riding out market volatility sounds simple, doesn't it? But what if you've invested $10,000 in the stock market and the price of the stock drops like a stone one day? On paper, you've lost a bundle, offsetting the value of compounding you're trying to achieve. It's tough to stand pat.
There's no denying it – the financial marketplace can be volatile. Still, it's important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain. Though past performance doesn't guarantee future results, the long-term direction of the stock market has historically been up. Take your time horizon into account when establishing your investment game plan. For assets you'll use soon, you may not have the time to wait out the market and should consider investments designed to protect your principal. Conversely, think long term for goals that are many years away.
Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Though diversification alone cannot guarantee a profit or ensure against the possibility of loss, you can minimize your risk somewhat by diversifying your holdings among various classes of assets, as well as different types of assets within each class.
Asset allocation is the process by which you spread your dollars over several categories of investments, usually referred to as “asset classes.” These classes include stocks, bonds, cash (and cash alternatives), real estate, precious metals, collectibles, and in some cases, insurance products. You'll also see the term asset classes used to refer to subcategories, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state and local), high-quality corporate bonds, low-quality corporate bonds and tax-free municipal bonds. A basic asset allocation would likely include at least stocks, bonds (or mutual funds of stocks and bonds) and cash or cash alternatives.
There are two main reasons why asset allocation is important. First, the mix of asset classes you own is a large factor – some say the biggest factor by far – in determining your overall investment portfolio performance. In other words, the basic decision about how to divide your money between stocks, bonds, and cash is probably more important than your subsequent decisions over exactly which companies to invest in.
Second, by dividing your investment dollars among asset classes that do not respond to the same market forces in the same way at the same time, you can help minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, your assets in another class may be doing better. Any gains in the latter can help offset the losses in the former and help minimize a negative overall impact on your portfolio.
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