Posted On: 2006-11-27
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How do smart investors get that way? Are there some fundamental guidelines for making smart investing decisions? The answer is an emphatic "yes," and we'll explore these simple steps for choosing the right investments in this Fidelity Personal Finance podcast.
Ok. Let's begin. Perhaps the best way to feel more confident about our investment decisions is to gain a basic understanding of some key concepts. That way you can quickly and easily select investment that meet your needs. We'll now go over these concepts step by step.
Step one. Understand the difference among the investment types. Basically, there are three types of investments: stocks, bonds, and short-term investments. Each of these investment types offer unique advantages depending on your situation. But, by understanding the role each one plays, you can put together an investment mix to help bring you closer to your goals. First, let's talk about stocks, also known as equity investments. Stocks can give you the greatest potential for growth, but they also come with a highest investment risk. The value of stocks fluctuates in response to activities of individual companies, and general market and economic conditions. Generally, the more years until you need the money, the longer you have to ride out changes in the market, and the bigger role stocks can play in your investment mix.
The next type is bonds. Bonds or fixed income investments are generally less risky than stocks, so they can help offset some of the investment risks stocks can create. They do have an interest rate caveat, namely, as interest rates rise, bond prices usually fall. There are default and inflation risks to consider, but the potential risk and return on bonds is moderate, lower than stocks, but higher than short-term investments.
The last category is short-term investments. These include money-market or cash investments, which are considered the least risky of the three investment types. They also tend to produce the lowest returns over the long run. Short-term investments become more important as you get closer as to when you need the money.
So now that we've covered the main investment types, it's on to Step two. Determine your investment approach. Determining your investment approach, or put another way, discovering what type of investor you are, can help you choose the right investment mix. There are several factors to consider, including your time horizon, risk tolerance and financial situation. Let's see how your time horizon can influence your investments. The returns on stocks can fluctuate greatly over time, yet historically, stocks have outperformed bonds and short-term investments, and have offset the affects of inflation. The longer you have to invest, the better equipped you are to ride out fluctuations in the stock market, and the more aggressive your investment strategy can be. Next, you should know your risk tolerance. Before deciding on your risk tolerance level, there are two types of risks to think about. The risk that an investment will not generate the return you hoped for, this is called investment risk, and the risk...