6 Things You Think You Understand About Investing - But Really Don't

By Jean Folger | August 01, 2010 AAA

Profitable investing seems as straightforward as buy low and sell high, but the reality is that investing is a bit more complicated than that. Even if an investor relinquishes all control to a broker or fund manager, it is important that he or she still appreciates the basic principles of investing. While the average investor has at least a fundamental understanding of the principles, here are six investing considerations that for most investors warrant further study.

IN PICTURES: 5 Investing Statements That Make You Sound Stupid

  1. Risk
    The recent market meltdown, rife with panic and corruption, has probably driven home the point that investing is risky. Regardless, smooth-talkers and slick marketing will always be able to convince investors that the money is a sure thing. Different investment products carry varying degrees of risk, and it is vital that investors know what they are getting into prior to engaging in any investments.
    For example, short selling - selling a stock in the expectation that its price will drop (buy high, sell low for a profit) - entails an infinite amount of risk. If this type of trade moves against you, there is unlimited upside movement that can cause huge losses if left unmanaged. Bonds, on the other hand, typically grant investors far less risk, in exchange for more conservative returns.

    In addition to the flat-out risks associated with a particular investment instrument, it is important to analyze performance goals in terms of risk: how much am I risking in order to achieve a desired result? An investment strategy that risks more than the expected return (for example, a stop loss of $5,000 when the profit target is only $500) might carry an excessive amount of risk. Many investors adjust their investment strategies to fall within a specified risk-to-reward ratio.

  2. Impact of Fees
    Fees can significantly impact the bottom line of your investments. Whether they are brokerage fees, mutual fund expenses or trading platform fees, they are a reality in nearly any investment and can eat up a sizeable portion of your profits - or worse, the fees can add to your losses. It pays to read the fine print and understand exactly what you will be charged for each service, trade or investment. Some fees can be reduced or waived depending on your account size or monthly trading volume.
    Regardless of the size or type of fee, these expenses need to be considered as part of the overall investment portfolio. In certain cases, fees and expenses can be negotiated; speak with your account representative to find out how you can qualify for reduced fees. (For more, see Stop Paying High Mutual Fund Fees.)

  3. Power of Compounding
    Compounding involves the reinvestment of earnings. For example, a $10,000 investment that earns 5% will generate $500 during the first year, resulting in a $10,500 balance. During the second year, the 5% will be based on this larger number ($10,500) rather than on the initial investment; therefore, the investment will earn $525 dollars and be worth $11,025. Compounding is obviously most successful over time: the longer earnings are reinvested, the greater the value of the investment, and the larger the earnings will (hypothetically) be.

  4. Tax Implications
    Taxes are another reality of investing that can significantly chisel away profits. Understanding how each investment instrument is handled as far as the IRS is concerned is a vital part of an overall investment strategy. Active traders, for example, may apply for the mark-to-market (MTM) accounting election that allows reasonable expenses, such as monthly platform fees, to be a deductible business expense. Consulting with a qualified tax professional is an essential step in making the most of your investments and reducing your tax burden.

  5. Markets Change
    Unfortunately, your rock star investment strategy might be a one-hit wonder. What works in one market, or what is profitable during a particular market cycle, may not perform well under different conditions. Because markets change - along with the economy, consumer spending and saving habits, and other factors - a savvy investor needs to be on the lookout for these changes, and be ready to respond. (To learn how to start your investing journey, check out our Investing 101 Tutorial.)

    Investors can read reputable business periodicals, be aware of current events (and economic climates) and be open to change (when an investor is convinced his or her investment is a sure thing, it can be difficult to think objectively). Assuming an investment will continue to perform well is dangerous; while we are happy when our investments are profitable, we have to expect that something will change.

  6. Importance of Diversification
    The old saying "don't put all of your eggs in one basket" describes the basic theory behind diversification. Having a well-rounded investment portfolio is believed by many to be the most important factor in achieving long-term financial goals since it limits the overall risk to an investment portfolio.

    When an investor puts all their money in one stock, for example, they are at a greater risk of substantial losses than one who invests in, for instance, stocks, bonds and mutual funds - particularly those investment vehicles that would react differently to the same economic event (for example, investments in different asset classes). (To learn more, read our Introduction To Diversification.)

The Bottom Line

In addition to learning about different investment vehicles, investors must study the basic principles of investing, including risk and diversification, to employ the most sound investment strategies. Entire books have been written on each of the six topics mentioned in this article. As such, this article is only intended to be a brief introduction to these investing principles. Investors can enhance their portfolios and grow their wealth by understanding more about these six investment principles that deserve attention.

Catch up on your financial news; read Water Cooler Finance: Google Gains, Taxpayers Pay.

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