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There's nothing like the power of compound interest to supercharge your net worth. It's precisely why investing is a core part of financial wellness. But deciding where and how to invest your money to realize financial gains isn't always easy. Choosing an investment strategy will depend largely on your unique financial situation, goals, risk tolerance, age and other factors.
Whatever your strategy, the goal of investing is the same: to grow your wealth over the long term. Here are some actionable tips for choosing an investment strategy, along with the kinds of investments that might be involved.
How to Choose Your Investment Strategy
1. Set Financial Goals
Your financial goals will help shape your investment strategy. Most investors have an eye on retirement because it marks a big financial transition. Instead of earning a paycheck, you'll be drawing on your nest egg for income, possibly for decades.
Investing early and often is usually the best way to prepare for the future. That can start with deciding to set aside a certain amount of money each month for retirement. If you set aside $500 per month, for example, you could have over $220,000 after 20 years, assuming a 6% annual return.
You may also have pre-retirement goals. This can include everything from buying a home to paying for a child's education to starting a business. Investment gains could help you achieve those milestones. The right investment strategy should take all your financial goals into account so you can allocate a sensible monthly investment target.
2. Determine Your Risk Tolerance
Investing involves some degree of risk, and your appetite for it will likely guide your investment choices. Taking on more risk in your investment portfolio could open the door for greater future returns and help you keep up with inflation. High-risk investments are volatile by nature and include:
- Individual stocks
- Private companies (angel investing, IPO investing and venture capital investing)
- Peer-to-peer lending
- Hedge funds
- Real estate
The downside is that high-risk investments can leave you vulnerable to more severe losses. Investors are less likely to lose big with low-risk investments, though gains are generally less robust. Low-risk investments include:
A balanced portfolio is one that has a mix of both high- and low-risk investments.
3. Understand the Importance of Diversification
Diversification involves spreading your money among different types of investments, and it helps mitigate risk. A mix of investments in your portfolio can help cushion the blow of losses: When one section of your portfolio takes a hit, another might continue producing consistent returns.
This has everything to do with your asset allocation. The three main asset classes are stocks, bonds and cash or cash equivalents. Holding 60% stocks and 40% bonds is generally considered a solid mix, but it's not a one-size-fits-all rule. Younger investors have more time to recoup losses and add to gains, so putting more into stocks may make sense, while investors nearing retirement may want a more conservative approach to hold on to the nest egg they've built.
Some investors might prefer to take on more or less risk, or venture into alternative asset classes like cryptocurrency, real estate or private equity. As an investor, you get to choose the asset allocation that feels right to you based on your goals and risk tolerance.
Types of Investments
To choose an investment strategy, you'll need to know how different types of investments work. Here are some common types of investments.
Stock shares give investors an ownership stake in publicly traded companies. Their value tends to go up and down with regular market activity and company performance, but the goal is to buy stocks when prices are low—then sell them for more than you paid. Timing the market to the best of your ability is always a best guess. It can also be tempting to sell during market downturns.
Investing in individual stocks involves considerable risk. That said, it's still possible to see significant returns over time. The stock market has produced an average annual return of around 10% since the 1920s.
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Bonds are generally safer investments than stocks. To buy a bond is to lend money to the government entity or company that issued it. The investor is then fully repaid, with interest, upon the bond's maturity date. From 2001 to 2020, the average return for bonds was 4.8%, according to J.P. Morgan.
Series I bonds might be worth looking into. They combine two different interest rates—one that's fixed and one that responds to inflation. This composite rate, as it's called, tends to provide better returns than traditional bonds. The composite rate for series I bonds issued from May 2022 to October 2022 is 9.62%.
Mutual Funds and ETFs
Both mutual funds and exchange-traded funds (ETFs) allow you to buy small shares of different securities, like a collection of various stocks or a mix of stocks and bonds. They're investment vehicles that provide built-in diversification. Mutual funds are actively managed by a fund manager and typically have higher fees, while ETFs are usually passively managed and trade like stocks. Mutual funds and ETFs share some similarities but also have key differences.
These investments fall under the umbrella of socially responsible investing. Investors devote their dollars to companies that prioritize the environment, social issues or corporate governance. This allows you to invest with your values in mind. It's possible to find ESG retirement accounts, mutual funds, ETFs, individual stocks and index funds. ESG investing may also lead to potentially better investment returns. According to Morgan Stanley research, U.S. sustainable equity funds outperformed traditional funds by 4.3 percentage points in 2020.
Real Estate Investing
Those who want to play landlord can buy an investment property and rent it out to tenants. Another option is buying and flipping properties. Either way, investors should prepare to have a pool of cash on hand to cover repairs and other necessary maintenance costs. Financing an investment property also tends to be more expensive when compared with a residential home—you'll likely need a larger down payment and be met with higher interest rates.
Real estate investment trusts (REITs) allow you to invest in publicly traded companies that own real estate portfolios. Risks and costs both tend to be lower, which could make for a good entry point into real estate investing.
Once you know the different types of investments, you need to figure out what to do with them. Following are different strategies to consider.
- Buy and hold: This approach involves holding an investment over the long term in the hopes that its value will go up over time. Buying and holding is the opposite of selling off investments during market downturns. It can also save you in taxes: Capital gains tax applies to most assets that are sold for a profit. Long-term tax rates are generally more favorable than short-term rates.
- Growth investing: This investment strategy zeroes in on stocks that are expected to be more valuable in the future than they are today. Investors use a stock's strong past performance as an indicator of future value. It's essentially betting that a stock will continue on a positive trajectory. Growth investments are generally considered risky.
- Value investing: Unlike growth investing, value investing is all about buying stocks that investors believe are currently undervalued. The hope is that stock prices will increase once the market recognizes their authentic worth. Determining which stocks have this hidden potential can be tricky, which is why value investing is generally more affordable than growth investing.
- Passive investing: Index funds are an example of passive investing. These low-cost mutual funds or ETFs track a specific market index, investment trend or sector. This is different from having a fund manager who actively picks a fund's securities to try to beat the market. Costs are generally lower, though it may take a little longer to realize gains when compared with riskier investments.
- Dollar cost averaging: Instead of investing a lump sum, you'll invest a set dollar amount on a regular timetable—regardless of what's happening in the stock market. Setting aside the same contribution amount for your 401(k) account every paycheck is an example of dollar cost averaging. It reduces the odds that you'll invest when prices are high. This strategy is meant to help you sidestep the dangers of market volatility.
How to Start Investing
- Leverage retirement accounts. Your employer is a great place to start. If you have access to a 401(k), it's wise to contribute at least enough to secure an employer match. You can also open an individual retirement account (IRA) yourself. Both traditional IRAs and Roth IRAs offer unique tax advantages. Your retirement account provider should be able to explain your investment options.
- Work with a financial advisor. A financial advisor can help you create an investment plan that's tailored to your financial goals, risk tolerance and retirement timeline. Beyond that, they can also guide you on things like estate planning, taxes, budgeting and more.
- Consider a robo-advisor. Robo-advisors are virtual automated investing services that are often more cost-effective than financial advisors. The process usually begins with an online questionnaire designed to reveal things like your timeline, risk tolerance, income, assets and financial goals. The robo-advisor then uses that data to create and manage a customized investment portfolio.
- Open a brokerage account. This type of account allows you to invest in all kinds of securities, including stocks, bonds, mutual funds and ETFs. With a brokerage account, you can pull out your funds whenever you want—though you'll face a higher tax rate if you do so in a short period of time. Doing the same with a 401(k) or traditional IRA will trigger taxes on top of a 10% penalty if you're under 59½. With a brokerage account, you can make your own investment choices or partner with an investment manager or financial advisor to do the heavy lifting for you.
The Bottom Line
Your goals, age and risk tolerance all come into play when choosing an investment strategy. You'll then be tasked with deciding what to invest in and how. These things may change as you move through different phases of your life, but maintaining strong credit along the way is critical. Free credit monitoring with Experian can help you do just that, whether you're a seasoned investor or just starting out.