Knowledge is a valuable currency for investors, but a new survey from micro-investing platform Stash Invest suggests they still have a lot to learn about the market.
Forty-two percent of those surveyed didn’t understand inflation. Forty percent were clueless about compounding interest. And nearly half – 46 percent – didn’t understand diversification.
Brandon Krieg, Stash’s CEO and co-founder, says younger investors often lack basic knowledge about investing because it isn’t discussed in school or at home. They invest with the assumption that they can figure it out as they go. Learning about investing “is almost a lost art,” Krieg says. “There’s a very common theme: I don’t understand it, or I never learned, so I’ll do it later.”
But ignorance has a way of burning investors. So class is now in session, and the four lessons that follow are designed to help investing novices close the knowledge gap.
Inflation can’t be underestimated. Rising prices can affect investment returns more than you think. The higher inflation climbs, the more your purchasing power shrinks.
Inflation plays a major role in your retirement plan, says Albie MacDonald, managing director at MAI Capital Management in Ponte Vedra Beach, Florida. The longer you live, the bigger the impact of rising prices. “The best way to fight inflation is to plan for it and incorporate it into your budget,” MacDonald says. “The earlier you start investing, the more the market will be able to hedge against the impacts.”
Merlin Rothfeld, instructor at Online Trading Academy, an education website for investors, offers this example of how powerful inflation can be: “Assuming an inflation rate of 3 percent, if you had $100,000 in cash, after 10 years it would only buy you $73,742 worth of goods.” After 20 years, your savings would be the equivalent of $54,379 in purchasing dollars.
Treasury inflation-protected securities are one way to mitigate inflation’s erosive effect on savings. With TIPS, the principal of your investment increases with inflation. Historically, real estate investments also have been effective hedges against inflation. The best solution, says Rothfeld, “is to build a portfolio using a mix of investments that combat the rate of inflation while capturing the gains of the market.”
Diversification curbs risk. Too often, investors overlook the importance of diversification, says Tony Drake, certified financial planner and owner of Drake & Associates in Waukesha, Wisconsin. “There are people who work for one company their entire lives and they may have 60 to 90 percent of their portfolio in their employer’s stock,” Drake says. “There are others who are too heavily invested in one sector, like technology stocks.”
Both approaches are dangerous for the same reason. Too much exposure increases the potential for significant losses if the stock or sector you’re concentrated in suffers a downturn. “Keep in mind that individual companies or sectors will go through cycles,” Drake says. “Diversification keeps you from putting all of your eggs in one basket.”
By maintaining the right balance of investments in your portfolio, you curb the risk of one of them going off the rails. “The primary role of diversification is to mitigate volatility,” says Jeff Buckner, founder and co-chief investment officer at Plancorp in St. Louis. Although you can’t eliminate risk entirely, you can reduce it to make your portfolio more efficient “in terms of the return you get versus the risk you take,” he says.
Diversifying doesn’t have to be complicated. MacDonald says that a diversified portfolio should have multiple asset classes and sub-asset classes that tend to behave differently from one another. Such assets are said to have a low correlation.
For example, real estate and precious metals typically have a low correlation to stocks. Investments can also behave differently within the same asset class. For example, short-term bonds tend to fare better than longer-term bonds when interest rates are rising.
Rothfeld recommends expanding your investing scope to include a mix of stocks, commodities, futures, bonds and currencies. “The point is to spread the risk from being in an all-stock portfolio so that when the market drops you’ll benefit from upside gains in some of these other inversely related instruments.”
A diversified portfolio should reflect your risk tolerance and timeline. The Stash Invest survey found that a third of investors don’t understand the difference between conservative, moderate and aggressive portfolios.
If you’re young and your investments have decades to grow, don’t squander that gift of time by getting your allocation wrong. “For retirement investing, take advantage of your time horizon,” says Timothy Chubb, chief investment officer at Univest Wealth Management in Souderton, Pennsylvania. “Young investors tend to be conservative because they don’t want to lose money, but with a longer time frame, they’re doing a disservice to themselves by keeping it under the mattress.”