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Friday, January 02, 2009

Financial Basics Overview

You're not alone if you feel like you missed the class in school that taught financial basics. Even long-term investors occasionally want to brush up on the fundamentals. The bedrock concepts covered in this section can provide a sturdy foundation for meeting financial goals. Without a basic understanding of financial concepts, you will find it difficult to make good investing decisions.

Start with your financial goals

Before you choose investments, write down your financial goals-retirement children's education and so forth. For each goal, be sure to consider:
  • Your risk tolerance
  • Your time frame
The more time you have to reach your goal, the more choices you have. It's much easier to tolerate risk when you have plenty of time to ride out short-term volatility—the ups and downs in the value of your investment. A long time frame means you can choose to go after the higher long-term returns that equities have historically delivered.
Another advantage of a long time frame is that the more years your money compounds, the less you need to save to reach your goal.

Next understand your investment options

While there are hundreds of mutual funds to choose from, they mostly fall into 3 categories.
  • Equities (also called stocks)
  • Fixed-income (also called bonds)
  • Cash equivalents (a type of liquid investment such as a money market fund)
The risk of losing money with cash-equivalent investments is low, but so is the long-term return as compared with equities. With equities, the risk of losing money in the short run is much higher, but the potential for higher long-term returns is also there.
The best asset mix is a very personal decision. One size definitely doesn't fit all investors. If you're a long-term investor, investing solely in cash equivalents could leave you open to the risk of inflation. Short-term investors on the other hand, need to be more concerned with the risk posed by volatility.

Strategies for reducing risk

Successful investors use several strategies to reduce their investment risk including:
  • Diversification
  • Asset allocation
  • Rupee-cost averaging
Diversification is a big word that means it's not a good idea to put all your eggs in one basket. It' s not the same as asset allocation which is how you divide your money between stocks, bonds and liquid investments. The best asset allocation will give you the return you need while not having more risk than you can tolerate.
Even though your investment strategy is in place, you may be hesitant to start investing. Maybe the financial markets are ready to tumble. No one wants to invest at the wrong time, but investment professionals will tell you that there no way to know the perfect time. That's where rupee-cost averaging comes in. It' s an automatic investing technique-you put in the same amount at a regular frequency (monthly, for example).

source: Franklin Templeton
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