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Investing For Your Future
You should start by placing 1 to 3 months of income in a bank or credit union as an emergency fund. This money can be used for emergencies and to supply your needs should you become temporarily unemployed.
This money can be placed in savings accounts and CDs. These savings are insured by the federal government and you cannot lose any of the money you save in this way--unless you invest large sums of money.
After you have your emergency fund set up, you can look to begin a long term investment plan.
Long Term Investing For Your Future
For goals that are at least 5 years in the future, however, such as retirement, you may want to put some of your money into stocks, bonds, real estate, foreign investments, mutual funds, or other assets.
Unlike savings accounts or bank CDs, these types of investments typically are not insured by the federal government. There is the risk that you can lose some of your money. How much risk depends on the type of investment. Generally, the longer you have until retirement and the greater your other sources of income, the more risk you can afford.
For those who will be retiring soon and who will depend on their investment for income during their retirement years, a low-risk investment strategy is more prudent. Only you can decide how much risk to take.
Take Risks For Greater Long Term Returns
Why take any risk at all? Because the greater the risk, the greater the potential reward. By investing carefully in such things as stocks and bonds, you are likely to earn significantly more money than by keeping all of your retirement money in a savings account, for example.
The differences in the average annual returns of various types of investments over time is dramatic. Since 1926, the average annual return of short-term U.S. Treasury bills, which roughly equals the return of other cash equivalents such as savings accounts, has been 3.8 percent. The annual return of long-term government bonds over the same period has been 5.3 percent. Large-company stocks, on the other hand, while riskier in the short term, have averaged an annual return of 11.2 percent.
Diversity to Reduce Investment Risk
There are two main ways to reduce risk. First, diversify within each category of investment. You can do this by investing in pooled arrangements, such as mutual funds, index funds, and bank products offered by reliable professionals. These investments typically give you a small share of different individual investments and will allow you to spread your money among many stocks, bonds, and other financial instruments, even if you don't have a lot of money to invest. Your risk of losing money is less than if you buy shares in only a few individual companies. Distributing your investments in this way is called diversification.
Second, you can reduce risk by investing among categories of investments. Generally speaking, you should put some of your money in cash, some in bonds, some in stocks, and some in other investment vehicles. Studies have shown that once you have diversified your investments within each category, the choices you make about how much to put in these major categories is the most important decision you will make and should define your investment strategy.
Why diversify? Because at any given time one investment or type of investment might do better than another. Diversification lets you manage your risk in a particular investment or category of investments and decreases your chances of losing money. In fact, the factors that can cause one investment to do poorly may cause another to do well. Bond prices, for example, often go down when stock prices are up. When stock prices go down, bonds have often increased in value. Over a long time -the time you probably have to save for retirement-the risk of losing money or earning less than you would in a savings account tends to decline.
The Right Investment Mix
How you diversify, that is, how much you decide to put into each type of investment, is called asset allocation. For example, if you decide to invest in stocks, how much of your retirement nest egg should you put into stocks: 10 percent ... 30 percent ... 75 percent? How much into bonds and cash? Your decision will depend on many factors: how much time you have until retirement, your life expectancy, the size of your current nest egg, other sources of retirement income, how much risk you are willing to take, and how healthy your current financial picture is, among others.
Your asset allocation also may change over time. When you are younger, you might invest more heavily in stocks than bonds and cash. As you get older and enter retirement, you may reduce your exposure to stocks and hold more in bonds and cash. You also might change your asset allocation because your goals, risk tolerance, or financial circumstances have changed. Additional Resources
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