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Family Finances: Understand The Risks Of Every Investment |
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Understand Your Investment Being successful with the family's money has less to do with having amazing investment skills than with understanding the categories of investments you have. Each investment has trade-offs. As risk increases, so do your returns and vice versa. The trick of successful investing is to balance the two so that you earn more and lose less. Perhaps the most effective New Year's resolution you can make is to understand basic investment categories. Then check the family's investments. Decide what's best for the future. Investments typically fall into these groups. Stocks. This is the riskiest category. When you buy stock, you are part owner of a company. Your greatest risk is that the company could go belly-up. Then the company's stock is worth nothing. Or, bad news about a company could send the stock price south. By contrast, stocks have historically outperformed most other investments over the long term of 10 years or more. Stocks, as measured by the Standard & Poor's 500 stock market index, have averaged annual returns of 10 percent. But to earn this kind of return, you need to own stocks for at least a decade. Don't rely on stocks if you need money soon. You don't have enough time to make up any losses. Be advised: Some stocks are less risky than others. For example, stocks that pay dividends are lower-risk than those that don't because you're earning periodic income that can help offset future losses. Utilities, which provide services most people can't live without, historically have been lower-risk. Bonds. With a bond you're the lender. You get a guarantee from your borrower -- a company or government. You get paid interest and your principal is returned to you when the bond matures. Most corporate bonds are backed by collateral -- assets of the company. Bonds are less risky than stocks because if your borrower goes belly-up, bondholders get paid before stockholders. But because bonds are lower-risk, they typically pay less. Bonds historically have averaged about 5 percent annually -- half the returns of stocks. There is no free lunch with bonds. Bond prices move in opposite directions to interest rates. Sell your bonds when rates are rising, and you will lose money. Also, a bond may be "called" prior to maturity. If rates drop substantially, your borrower may decide to return your principal, forcing you to reinvest at lower rates. Treasury bonds, guaranteed by the U.S. government, are lower-risk than corporate bonds. Short-term bonds are lower-risk than long-term bonds because their prices are not apt to fluctuate as much if you must sell them. Cash. This is the lowest-risk category. Cash is not money you put in a piggy bank. Rather, cash investments are short-term debt instruments such as CDs, U.S. Treasuries, corporate I.O.U.s, known as commercial paper, or money market mutual funds. Cash investments historically have returned less than bonds or stocks -- about 3 percent annually. They are considered lower-risk because in such a short term, there isn't enough time to lose much. However, commercial paper, corporate I.O.U.s, are riskier than Treasury bills, which are backed by Uncle Sam. Bank CDs are slightly riskier than Treasury bills, but typically will pay a bit more. Most other investments revolve around the above three categories. Mutual funds, for example, are professionally managed pools of investments, which may include any of the three groups. Once you understand an investment's risk and the potential return, you can make some decisions based on your goals. Perhaps, the easiest way to invest in stocks is to invest regularly in a well-managed stock mutual fund. You don't want to put all your money in stocks to make a quick killing if your roof is leaking and needs repair. But you don't want to have all your money in cash investments either. The return on your investment may not keep pace with increasing costs. You may not wish to own 20-year bonds if you think you might need to sell them to meet a financial emergency. Despite their higher rates, you could take a beating if interest rates rise. Struggling to pay rent? Cash investments are for you -- until you have managed to become a bit more financially secure. Once you've figured out the proper mix of investment categories for your specific situation, it's time to start researching the best-managed in each category. Then, sit back, relax, and have a prosperous new year! By Alan Lavine and Gail Liberman
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Credit Plus Health By Sean Toh All rights reserved.
