Your odds of winning the lottery are one in 15 million. Funding your future with lotto winnings isn't likely, given the odds. You'll have to take your financial future into your own hands if you hope to retire comfortably, and ease the anxiety of a hand-to-mouth existence. Such a well-funded fate requires an investment of your time before you invest your money.
One of the most difficult things for inexperienced investors is to stick with their asset allocation during times of volatility. When equity markets go up, investors feel good and want to invest more in equities. When markets go down, investors get skittish and want to be more conservative.
Financial planner David Walters
Lay a solid groundwork for your financial future by becoming familiar with the key issues and concepts in personal finance. One of fastest and most effective way to do this is to read, according to Irene Davis, a certified financial planner and certified public accountant. She recommends "The Richest Man in Babylon," "The Wealthy Barber," "Money Is My Friend" as three good primers.
You can also start by reading the business section of paper before checking in with columnists or sports scores. Make a habit of keeping an eye of the financial sector and jotting down words or phrases you don't understand or conclusions you find hard to swallow. Note terms you see frequently, such as "mutual fund," "hedge fund" and "index traded fund." Follow up by talking to a friend or colleague knowledgeable in personal finance, or do research yourself. "Truly understand how a particular investment can 'make you money,'" before you put up any money, said Davis, and keep asking questions until you are confident you grasp the issue at hand.
Pay Yourself First
Compound interest is a powerful tool, so start saving and investing early. Investors who start saving early give themselves a longer time horizon for their investments to compound and grow, according to Kevin O'Reilly, an Arizona based investment advisor and principal at Foothills Financial Planning.
"An individual who starts investing $10,000 per year at age 35 will have $1.13 million at age 65, assuming an 8 percent average rate of return. If he or she had started at age 25, that number would be $2.6 million," O'Reilly said. Although an 8 percent rate of return may seem high in the current economic environment, it would not be unexpected over 30 years.
Starting early also establishes a good habit for your long-term financial well being. And while it may not be reasonable to shoot for investing $10,000 a year right now, you should work up to investing at least 10 percent of your paycheck. Even investing only $2,000 a year at 8 percent interest for 40 years will net more than $518,000.
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"You can't make up for lost compounded returns if you start investing too late in life," O'Reilly said.
Do Your Homework
Do thorough research to ensure you pick quality investments. One simple way to do this is to invest in what you know and use, said Robert Laura, a partner with the Michigan based Synergos Financial Group.
"Don't turn on CNBC or surf the Internet for hot stocks. Walk around the house and read labels to the products and services you use. If you would recommend them to someone else, do some research on them and then start there," Laura said.
It's ill-advised to invest in anything you can't explain or track with the Wall Street Journal or with a finance Web site like AOL Finance or Morningstar, so take an in-depth look at a sector before investing. "It is important know how each sector has performed recently before investing and the future prospects of that sector," Laura said. "Why go into emerging markets if it's up 70 percent year over year?" he said. While strong year-over-year growth is great if you already own stock, a quick rise could indicate you're too late to capitalize in that market.
Diversify Your Assets
Spread your money over non-correlated assets, geographies, industries, and investment types. That means investing in assets whose performance – positive or negative – will not affect each other. Determine an asset allocation for your investment portfolio based on your investment time horizon and risk tolerance.
Your asset allocation should be a mix of equity (stocks) and fixed-income investments (bonds) that will perform differently in varying market environments. Financial planner David Walters recommends more aggressive asset allocation for those in their 20s or 30s who won't withdraw assets from the portfolio for 20 or 30 years.
Your age represents the percentage of your assets that should be invested in mutual funds. For instance, if you are 35 years old, your portfolio should be weighted with 35 percent bonds for safety. As you age, the percentage in bonds increases to limit your exposure to market volatility.
Walters recommends investing in varying asset classes and market sectors. "Stick with mutual funds or exchange- traded funds, which are a simple and inexpensive way to get broad diversification amongst an asset class," Walters said.
Stay Your Course
Determine your asset allocation and stick with it until your time horizon or other factors dictate a shift. Day-to-day fluctuations in the market shouldn't cause investors to lose perspective. Invest on a regular schedule, such as $100 each month, a practice called dollar-cost-averaging. Fight the urge to use your portfolio to entertain yourself. Don't tinker with your investments daily – think long-term.
"One of the most difficult things for inexperienced investors is to stick with their asset allocation during times of volatility. When equity markets go up, investors feel good and want to invest more in equities. When markets go down, investors get skittish and want to be more conservative," said Walters. Recent market volatility has made this particularly true over the past several years.
Cut Your Costs
Keep your portfolio costs to a minimum; this is key to maintaining a profitable rate of return. While mutual fund expense ratios and trading commissions may not seem like much, they add up over time. "Ignoring these costs can easily cost you 1 percent to 2 percent of your portfolio return annually," said Ilene Davis. "Compounded over a number of years, this can have a significant drag on the value of your retirement portfolio."
Investing $10,000 per year for 40 years at a rate of 10 percent will amount to just under $4.4 million. Losing just 2 percent of that investment to broker fees or transaction costs could cut your yield in half.
Expenses matter. Because of the magnitude of small differences in the rate of return demonstrated above, it is critical to understand how much an investment costs. Many investors pay no attention to the expense ratio for their selected mutual funds, said Kevin O'Reilly.
"These expenses can vary by 1.5 percent or more. Paying too much for a mutual fund can be very damaging to a portfolio. Furthermore, the evidence is overwhelming that higher expense funds do not, on average, perform better than lower expense funds. In other words, there is no correlation between higher expenses and better performance," said O'Reilly.