Investing your money can help you grow your savings faster. But the number of investments you can choose from is large, and each comes with its own pros and cons.
The mix of securities you choose can determine how successful you are at meeting your goals. And before you actually invest in them, you should ask yourself these four questions.
1. Does it match your risk profile?
As tempting as investing in a stock or mutual fund is because it could earn you a lot, it may not be well fitted for your risk tolerances. Sure, you could make a lot of money when the stock market is doing well. But when a bear market is in effect and stock prices are going down, these investments might perform worse. For example, over the last 20 years, investing in large-cap stocks would've earned you an average rate of return of 9.06%. You would've seen your accounts increase by 32.39% in the best year, but you also would've seen them decrease by 37% in the worst year.
That's why the first consideration you should make when you invest is whether you feel comfortable with these numbers. Are you as happy with the downside risk as you are with the upside potential? If not, consider investing in something less risky. It might result in a lower average rate of return but could provide you with peace of mind during volatile times.
2. How similar is it to your other investments?
From year to year, various investments perform differently, and one certain sector or industry might greatly outperform others. Growth stocks might do better than value stocks, and bonds could even rank at the top of the performance charts in a bad market cycle.
For instance, in 2018, large-cap stocks lost 4.38% of their value, but emerging-market equities did even worse and lost 14.57%. Bonds ended the year flat, and if you had held this more conservative investment, you would've fared better. It would be great if you could predict which would do the best each year, but it's probably impossible. Diversifying your holdings is one way to make sure that you have some of everything and to avoid putting too many of your dollars into an underperformer.
When you add new investments to your mix, making sure that you maintain a good level of diversification will involve examining how closely your new holding mirrors your old ones. If it maintains or increases diversification, great, but if it doesn't, it could put you into a higher risk category than you want.
3. How has it performed in the past?
Projections of how your account could grow in the future are largely based on how the investments you hold have done in the past. And while past performance is not a guarantee of future performance, it can be a gauge you can use for planning purposes. Not only will in investment's history give you a good idea of the level of risk you're taking on, but it could also help you prepare for your long-term goals.
For example, if you have a goal of growing your retirement accounts to $1 million and you have 30 years to do it, understanding the rate of return you could receive can help you figure out how much money you should contribute to your accounts each year. If you determine that the rate of return your investments have earned on average is 8%, you can calculate that saving $8,250 each year could get you to that goal if these average rates stay the same.
Just make sure you review your account at least once a year in case the rate you're using changes significantly. Make any necessary changes to your growth projections and contributions so you stay on track.
4. Will you hold it for the short or long term?
Whether you will use the money you're investing for a short-term goal like buying a house or a long-term goal like saving for retirement can be a huge factor in deciding whether a particular instrument is suitable for your account. Even if you have a high tolerance for risk, your ability to take risk is probably going to be lower for money you plan on using soon.
If the stock market crashes and these accounts are heavily invested in riskier holdings, it could make meeting your goals harder. Even for something like retirement, as you near the date when you will use the money, you might want more conservative investments. Making sure the ones you choose are in line with your time horizon can help you avoid actions like selling out of your investments because of fear that losing money will derail your plans.
Not every investment will be suitable for you. Understanding what you're buying and making sure that it's a good fit can help make the journey to your goals less bumpy.