Step 4: Learn About Investment Strategies
There are some basic investment strategies that every beginning investor should understand before putting their savings on the line.
When you're building your first investment portfolio, your broker will probably suggest that you put most of your money in stocks. But if you read the financial page, you know that the stock market can take big dips and unpredictable jumps. Isn't putting so much money in stocks too risky? On one hand, you're right -- stocks are riskier than other investments like bonds or money market accounts.
But you're also confusing short-term volatility with long-term risk. The truth is that the stock market has always crept higher and higher over the long-term, even if there are a few rough years along the way. As a young investor, you can wait out those bad years. Kiplinger.com puts it this way: "Invest aggressively for the long-term and conservatively for the short term" [source: Kiplinger]. If you're putting money away for 30 years, go for stocks. If you're saving money for next year, put it in something ultra-safe, like a CD.
Another important principle of investing is something called dollar-cost averaging (DCA). The problem with investing in something like the stock market is that it's hard to know when stock prices are going to go up and when they're going to go down. And as a beginning investor, you don't have the time or money to waste responding to every slight market fluctuation.
DCA takes a lot of the guesswork out of investing. Every month, you invest the same exact amount of money -- whether it's $25, $100 or $500 -- in the same investment instrument. Let's use stocks as an example. Every month you buy $100 of Microsoft stock. When the price of Microsoft stock is down, that $100 will buy you more shares. When the stock price is up, the same $100 will buy you less shares. The result, over time, is that you end up buying Microsoft stock at an average price per share.
That average price per share is guaranteed to be better than anything you could have come up with by jumping in and out of the market, trying to guess when Microsoft stock had bottomed out and predicting sudden upturns. With DCA, "bad" months aren't really that bad, because you pick up more stock during those months to offset the "good" months when the stock price is back up. Even if you have a large lump sum to invest, like $10,000, consider breaking it up into 10 $1,000 investments spread over 10 months. It's much safer than trying to pick the exact right moment to invest everything at once.
Mutual funds are ideal for dollar-cost averaging. Many mutual funds allow investors to automatically deposit a set dollar amount each month. For beginning investors, this is perfect, because there's usually no minimum, and it's a great way to get into the habit of investing regularly.
But the real benefit of using DCA with mutual funds has to do with the fee structure. Most mutual funds charge a commission based on a fixed percentage of your investment, say 0.2 percent. So if you invest $50 every month in your mutual fund, you'll be charged 10 cents for the transaction. If you tried to do the same thing with stocks, you'd be charged $15 or $30 for that same $50 transaction, because stockbrokers get paid by the trade. So instead of paying 0.2 percent in fees, you're paying 30 or 60 percent.
In the next section, we'll explain how to build and maintain a balanced investment portfolio.