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Risk and Return. Whenever you invest money, there is a risk of loss of some or all of that money. An important principle of financial literacy and investing in general, is that risk and return are closely associated . The lower the risk, the lower the potential rate of return on the investment; the higher the risk of loss, the higher the potential return. Different types of investments have different risk levels. Risk tolerance is a personal thing. Some people are comfortable with higher risk, more aggressive investments. Others sleep better knowing that, although their more conservative investments may not have a high return, their hard-earned money is not at risk. Diversification. You’ve probably heard your mom warn “Don’t put all your eggs in one basket!” Experts recommend that investors diversify their portfolio . This means investing in a variety of different types of investments with different risk levels and within different industries. Diversification is a risk management technique that spreads investments around to protect against loss. If one investment fails, the others aren’t impacted, so your wealth can’t be wiped out by one loss. Alignment. Once an investor has identified their long term financial goals and the time frame within which they want to achieve those goals, they are better able to align their investments with their needs and risk tolerance level. If a high ROI is needed to reach their goal within their time frame, they will select more aggressive investments with a potentially higher ROI. If a high ROI is not essential, or if an investor is just risk-averse in general, they will consider lower risk investments. Assume, for example, an investor has $10,000 which she wants to grow to $15,000 in 5 years so she can start a business. Using an investment calculator, she would learn that, to reach her goal, she would need about a 10% annual rate of return. That means she would select investments that could potentially provide a return in that range. Obviously, she could rule out investing in a CD, which has very low rate of return. She would have to look at stocks or other riskier investments. When you begin investing, consult a qualified and reputable investment advisor to help you select investments that align your investment goals, time frames, ROI, and tolerable levels of risk . Reflect on Learning: An investment calculator is a very useful tool to help determine the rate of return on investment (ROI) an investor needs in order to achieve a financial goal within a particular time frame. Go to www.bankrate.com/calculators/retirement/investment-goal-calculator.aspx and solve for the following: Let’s say your long term financial goal is to have $20,000 to start your own business in five years. You open a brokerage account with a deposit of $1000 and plan to add $300 per month for the next five years. What rate of return must you have to reach your goal? Answer: About 5%. What can you do to reach your goal sooner? Answer: Make a higher initial deposit, make higher monthly deposits, or get a higher rate of return. PRODUCT PREVIEW
II. Types of Investments Asset Class. Investing means acquiring assets which will increase in value over time. Assets are grouped by class . The traditional investment asset classes are equities, debt, real estate, and cash. An investor’s collection of assets is referred to as their investment portfolio . For example, if you own an IRA, it becomes part of your investment portfolio. If you buy stock in a company or own a rental property, these assets are
Traditional asset classes are equities, debt, real estate , and cash .
Chapter 11 | Investing 101 200
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