In the late 1990s, many investors enjoyed the fruits of positive double-digit returns with their equity investments. Then, during the period of January 1, 2000, through December 31, 2002, the S&P 500 lost more than 40% of its value, and so did the portfolios of many investors. Then, a similar cycle repeated itself again, ending in a market crash in 2007-2008. Such volatility can be disturbing to portfolio performance and ignite fear in investors. However, history has shown that financial markets will reward investors for the capital they supply over the long term.

If you understand all the different types of accounts available and implement a disciplined investment strategy you will increase your chances of success. Do you have a written monthly budget? What is your discretionary income? With pension plans disappearing and Social Security on the rocks, we will show you what you need to do to succeed in achieving your financial goals.

Understand Your Investments
In order to enhance your investment returns, it's important that you understand the fundamentals of equity (stock) and fixed-income (bond) investments. (To learn the basics of investing, see Investing 101: A Tutorial For Beginner Investors.)

Three Equity Factors

  1. Equities (stocks) have had historically higher expected returns than fixed-income investments (bonds).
  2. Small company stocks have higher expected returns, but higher volatility, or risk, than stocks from large companies. (To read about portfolio risk, see How Risky Is Your Portfolio?)
  3. Lower priced value stocks have higher expected returns than higher priced growth stocks. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk. (To learn more about this topic, read Risk And The Risk Pyramid and Working Through The Efficient Market Hypothesis.)

Two Fixed Income Factors

  1. Longer term instruments are riskier than short-term instruments due to the longer exposure to interest rate risk.
  2. Lower credit quality issues are riskier than high credit quality issues, but offer a higher rate of return if there is no default.

Diversification is a strategy that can be summed up by the timeless motto, "Don't put all your eggs into one basket." The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will make up for those losses. The key to a well diversified portfolio is to allocate your assets with mindset that "negatively correlated assets help reduce risk". (To read more about diversification, see Modern Portfolio Theory: An Overview, Introduction To Diversification, The Importance Of Diversification and A Guide To Portfolio Construction.)

What do we mean by negative correlation in a portfolio? This is the process of finding asset classes that perform differently. For example, commodities tend to perform differently than the S&P 500, and real estate investment trusts (REITs) tend to perform differently than the Dow. By mixing these types of asset classes in your portfolio, you enhance your chances of making money when U.S. markets are underperforming.

The U.S. stock market is presently less than half the size of the total world stock market, so if you're not investing internationally, you could be missing out on some great investment opportunities. Determining the perfect amount of money to allocate to the different asset classes is the tricky part.

Asset Allocation
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, alternative investments and cash. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk. (To find out more about asset allocations, see Five Things To Know About Asset Allocation, Achieving Optimal Asset Allocation and Asset Allocation Strategies.)

A Brinson, Hood and Beebower 1986 paper entitleded "Determinants of Portfolio Preference" analyzed quarterly return data of 91 large pension funds over the period 1974 to 1983. Its main conclusion was that 94% of the variability of total portfolio returns is explained by strategic asset allocation, with security selection and market timing playing minor roles, although many active stock managers tend to challenge this study.

All investments have some degree of risk. In an investor's portfolio, risk is typically measured by using a number referred to as standard deviation. The more risk that you are willing to absorb in your portfolio, the greater the potential for a higher return. When you determine an acceptable level of risk for your situation, you can then work on developing your asset allocation. You can use the standard deviation associated with specific asset class indexes to get a feel for the amount of risk your portfolio will assume. When your asset allocation is in place, consider annual or semiannual rebalancing. Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time, some of your investments may become out of alignment with your investment goals. (To explore rebalancing further, see Rebalance Your Portfolio To Stay On Track and New Year's Resolutions To Improve Your Finances.)

Final Thoughts to Help Enhance Wealth
1) Seek out Dividends
Volatility of the markets causes stock prices to rise and fall, but income is generally positive. If you seek out income-producing investments such as bonds, money market funds, high-dividend-paying stocks and income trusts, you can protect your portfolio during market declines. Because companies don't like to cut or reduce their dividends unless it is in the direst circumstances, a dividend is paid to you whether the stock price is rising or falling.

2) Implement Dollar-Cost Averaging
Most successful investors invest money on a regular basis using a process called dollar-cost averaging. This is the practice of investing the same dollar amount at consistent intervals. This allows you to purchase shares at various points in the market - both during ups and downs. (Learn more about dollar-cost averaging in DCA: It Gets You In At The Bottom and Dollar-Cost Averaging Pays.)

3) Consider Taxes
Taxable accounts can generate a high tax bill if not invested properly. While high-dividend investments are great, they will produce significant taxable income. Try to buy these high-dividend investment types in your individual retirement account (IRA) or other tax-deferred accounts to avoid the tax liability. Utilize tax-managed mutual funds to help reduce the year-end taxable capital gains distributions.

4) Maximize "Free-Money"
Use retirement and education accounts effectively. Roth IRAs and 529 Plans are incredible investment vehicles if you follow the rules - your earnings in both accounts will never be taxed! In employer-sponsored retirement plans such as a 401(k)s, 403(b)s and SIMPLE IRAs, many employers offer a matching contribution. If you're not taking advantage of this "free-money" from your employer, you'd better rethink your investment plan. Take advantage of these plans and defer income into them - it will also help reduce your tax bill.

There is a lot of "financial pornography" out in the world that will try to steer you clear of a long-term disciplined approach, such as a hot stock investment, inappropriate hedge fund and, basically, some investments that you will never understand. To alleviate the confusion, work with an independent financial planner, preferably a Certified Financial Planner that is held to a fiduciary standard to act in your best interests. Ensure that he or she understands your time horizon and explain all of your investment choices and the risks associated with them. Do your homework and check out a few different planners before you make your final decision. The most successful client and advisor relationships are based on trust, so make that a top priority. Experience will teach you that if you maintain a disciplined investment policy, invest on a regular basis and stay focused on the long term, you are sure to reap the rewards.

Related Articles
  1. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  2. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  3. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
  4. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  5. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  6. Investing

    What’s Plaguing Twitter and Yelp?

    Yelp and Twitter have recently become grounded in reality and unable to justify their sky-high stock valuations.
  7. Mutual Funds & ETFs

    ETF Analysis: ETFS Physical Platinum

    Learn about the physical platinum ETF. Platinum embarked on a bull market from 2001 to 2011, climbing to record prices along with other precious metals.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  10. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
  1. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  4. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  1. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  2. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  3. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  4. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>
  5. Can I take my 401(k) in a lump sum?

    Establishing a retirement savings plan during your working years is a necessary part of comprehensive financial planning. ... Read Full Answer >>
  6. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!