Many money lessons learned – the hard way
Editor’s note: Dr. Michael Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University. He teaches about and writes on personal finance, economic outlook, and public policy.
RALEIGH, N.C. — It’s certainly not been pretty – in fact, it’s been downright scary. Only a couple of times in our history have the financial markets plunged as much as they have in recent weeks. Investors are receiving all kinds of advice – buy, sell, stay put – with much of it contradictory. It’s no wonder most folks don’t know what to do.
I won’t pretend to try to predict where the stock market is going. Instead, I’ll take this opportunity as a “teachable moment” – when financial matters have people’s attention – to highlight some age-old investment principles. Hopefully, these principles will help prepare you for the next rough money road.
Know where your money is invested
It’s amazing to realize, but many people simply don’t know where their money is invested. Take the example of two common retirement investments – the 401(k) and the IRA. Many people think these are types of investments. They’re not; they are ways of holding your money. Funds put into a 401(k) or IRA account still must be allocated to specific investments such as stocks, bonds, etc.
So now is a great time to find out what specific investments are receiving your 401(k) and IRA money. If you think the investments are too risky or haven’t performed well, then change the allocation. If you don’t know what a particular investment option means, then ask someone who does. By all means, don’t assume anything – keep asking questions until you know what’s happening to your money.
Diversify, diversify, diversify
It’s the oldest investment recommendation in the book – to spread your investment eggs among many baskets. There are two reasons for following this strategy. First, there is no consistent, foolproof way of knowing which investment eggs will hatch and which won’t at any point in time. Many have tried, but the economy is simply too complex and tricky to always know which investments will perform well and which won’t.
This means a simple, but very logical, approach is to always have some money in all the major kinds of investments, such as stocks, bonds, metals (gold), real estate, and short-term interest paying accounts. This leads to the second advantage of diversification – rarely, if ever, do all of these investments move together. This means that if stocks go down, something else in your portfolio will go up to counter the losses. Yet over time, a well-balanced, diversified portfolio will pay a modest, yet consistent, rate of return.
Know your mutual fund
Mutual funds aren’t created equal. Similar to 401(k)s and IRAs, mutual funds are a way of funneling money into investments. Specific investments still must be selected and held in the mutual fund. This means mutual funds can vary all across the board in terms of the investments they hold and the level of risk they take. So, once again, now is a great time to pull out your mutual fund statements and determine exactly where your money is.
The many faces of risk
With the nosedive in the stock market this year, everyone is concerned about “preservation of principle,” meaning protecting the original money put into the investment. The risk of losing your original invested amount is obviously high with the stock market, but is virtually non-existent with an insured certificate of deposit. Right now, everyone wants to be in those insured CDs.
The risk of losing your original money is only one kind of risk, however. There are many others, such as the risk of not earning enough to keep up with inflation and the risk of not being able to easily convert your investment to cash. While safety is of prime importance now, it’s not the only risk factor to consider.
Age rules
While there are many characteristics that determine what investments are right for each person, perhaps the dominant characteristic is age. The reason is that time can correct investment mistakes. This is why it’s often recommended that young investors put a greater share of their money in higher-risk – yet potentially higher-earning – stocks and real estate. The notion is that while downturns in these investments will occur (like now), stocks and real estate pay handsome returns over the long haul.
The opposite applies to older investors, who will soon need to access their money. Here, safety is the priority because there may not be enough time to overcome losses.
Crises tend to focus our attention. Thus, a silver lining in today’s financial crisis may be that it’s focusing people’s attention on their money and their investments. You decide if the investment principles stated here will eventually steer your investment ship in the direction you want.
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