Here are some of the core concepts of investing that everyone should know. Whether you are a new or more experienced investor, it is important to understand these core concepts when evaluating an investment opportunities or making an investment decision. These core concepts can help you to have a foundation of a sound investment strategy.
1. The Magic of Compounding
Compound interest is the eighth wonder of the world, as reportedly said by Albert Einstein. It makes your money grow by earning interest. Simply put, compounding pays you earnings on your reinvested earnings by paying interest that has been added to your principal amount. For example, imagine an investment of $100 and are able to earn 10% on that money, in year your $100 will have turned into $110. The next year, assuming you did not have any withdrawals and still be able to earn interest of 10%, your initial $100 plus the additional $10 interest will be the base on which earnings can accumulate. So, the total earnings at the end of year two will be $121. The longer you leave your money work for you, the bigger the earnings will be and the more you will potentially benefit from compounding.
2. Portfolio Diversification
When it comes to investing, there is something we can be certain of – not all investment assets will perform equally. Diversification can help in minimizing the risk of your portfolio but not totally eliminating it which is really a smart move. Once you diversify, you can benefit no matter which direction the market is going without playing the losing game of trying to time the market. Remember, when it comes to diversifying your portfolio, identify the asset classes that are appropriate for you, decide the percentage of how much should be invested to each asset class and assess your risk tolerance.
3. Risk Tolerance
“How much money can I afford to lose?” is the question you need to answer to make decision about your investments. Understanding risk tolerance can help you manage your investment portfolio and can make a large influence to your investment decisions. There are lots of risk tolerance’s questionnaires that can help you quantified your ability to handle the ups and down of the market but the readings are not exact. It only gives you an idea in assessing on how much money you are comfortable of losing when your investment is having a bad year. In assessing your risk tolerance, it can be useful to review the historical data of each class of assets and knowing the factors that affect it. Your risk tolerance can be measured by your willingness to undertake risk, your ability to take risk, and your investment time horizon.
4. Time Value of Money
This key investing principle states that a dollar on hand today is worth more than a dollar to be received in the future. So, if you start investing today you begin earning money and if you start now the more time your money will grow and work for you. This, of course, depends upon the rate of return or the interest rate. Remember, that time is the greatest ally when it comes to investing. The two areas of time value of money are computed based on its Future Value and Present Value. Future Values is the process of finding what an investment today will grow in the future while Present Value is determining what a cash flow to be received in the future is worth in today’s dollars.
5. Rate of Return
It is a great tool to use in evaluating whether the investments you own are performing in the way you expect. It is expressed as the percentage increase over your initial investment cost. Smart investors used this to weigh the risk of an investment against the potential return because in a capitalist society, once you invest money into something, it is important to know how much you are having in return whether it is a gain or loss and the amount of time it will take to generate income.
6. Dollar-Cost Averaging
This final concept is a simple yet best strategy that is used by investors to add to their holdings by slowly investing a fixed amount of money at regular intervals, to buy more shares while it is priced cheaply in the market and buy fewer shares when it is more expensive. This spread the cost of your investment because you used the average cost and overtime it helps smooth out the bumps of the price fluctuations of your investments. If you are a beginner in investing, this strategy can help you to invest in an affordable and easy way because you don’t need to worry to time the market and it get you into the habit of investing.
These core concepts affect the way you make your investing decision whether consciously or subconsciously. Always remember that having a basic knowledge of these investing concepts can help you build a sound portfolio and strategize effectively to achieve your financial goals.