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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, basic principles may help you invest more successfully.
A previous blog post focused on long-term compounding, enduring short-term pain for long-term gain, and asset allocation. Here are three more basic principles to take into account.
Liquidity refers to how quickly you can convert an investment into cash without loss of principal (your initial investment). Generally speaking, the sooner you'll need your money, the wiser it is to keep it in investments with comparatively less volatile price movements. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in an investment whose price is currently down.
Therefore, your liquidity needs should affect your investment choices. If you'll need the money within the next one to three years, you may want to consider putting the funds into certificates or a savings account, which are insured by government agencies – the Federal Deposit Insurance Corporation (FDIC) at banks and the National Credit Union Administration (NCUA) at credit unions. Short-term bonds and most money market accounts are neither insured nor guaranteed by the FDIC, NCUA or any other government agency, but they are easily accessible in the short term. Your rate of return will likely be lower than with more volatile investments such as stocks, but you'll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day.
Note: If you're considering a mutual fund, evaluate its investment objectives, risks, charges and expenses. You’ll find this information outlined in the prospectus available from the fund. Consider the information carefully before investing.
Dollar cost averaging is a method of accumulating shares of stock or a mutual fund by purchasing a fixed dollar amount of these securities at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less; when prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.
Remember that, just as with any investment strategy, dollar cost averaging can't guarantee you a profit or protect you against a loss if the market is declining. To maximize the potential effects of dollar cost averaging, you should also assess your ability to keep investing even when the market is down.
An alternative to dollar cost averaging is trying to “time the market” to predict how the price of the shares will fluctuate in the months ahead so you can make your full investment at the absolute lowest point. However, market timing is generally unprofitable guesswork. The discipline of regular investing is a much more manageable strategy, and it has the added benefit of automating the process.
Unless you plan to rely on luck, your portfolio's long-term success will depend on periodically reviewing it. Maybe your uncle’s hot stock tip has frozen over. Maybe economic conditions have changed the prospects for a particular investment or an entire asset class.
Even if nothing bad happens, your various investments will likely appreciate at different rates, which will alter your asset allocation without any action on your part. For example, if you initially decided on an 80% to 20% mix of stocks to bonds, you might find that after several years the total value of your portfolio has become divided 88% to 12%. (Conversely, if stocks haven’t done well, you might have a 70% to 30% ratio of stocks to bonds.) The point: You need to review your portfolio periodically to see if it’s smart to rebalance or return to your original allocation. To rebalance your portfolio, you may buy more of the asset class that’s lower than desired, possibly using some of the proceeds of the asset class that is now larger than you intended.
Another reason for periodic portfolio review: Your circumstances change over time, and your asset allocation will need to reflect those changes. For example, as you get closer to retirement, you might decide to increase your allocation to less volatile investments or those designed to provide a steady stream of income.
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