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Fundamentals of investing and working with a financial professional
Every successful retirement begins with a plan. While Transamerica believes that working with a financial professional is best, it is also important for you to be aware of the fundamentals of investing so you can shape the plan that is right for you.
If you're like most people, you want to build enough wealth to have and experience the things you want out of life.
But getting there can seem like a daunting task, especially if you're new to investing. Knowing the few key basics outlined below is a good starting point, and can help you hold meaningful discussions with a financial professional who can assist you in developing a personalized investment plan.
First, ask yourself: "When will I need the money I'm setting aside?"
If you will need your money within 3 to 5 years, it's generally best to save it in a short-term vehicle that allows you ready access without a withdrawal penalty - such as a bank savings account or a money market fund - where there is little risk of losing money.
For longer time horizons (5, 10, 20, or 30 years+) it's generally best to invest for long-term growth in a diversified mix of investments - even though there may be a greater degree of risk that you may lose money.
Risk vs. reward
Why invest if there is a risk of losing money? Because "risk" and "reward" are two sides of the same coin. If you choose not to risk your money, you should reasonably expect a lower return. Conversely, if you accept greater risk, you would expect the potential for proportionately greater rewards.
The longer your time horizon, the more likely you are able to financially withstand an investment's poor short-term performance because there is still the potential for achieving a higher average return over time.
Types of investments
Most investments fall within three basic categories, or "asset classes": cash (or cash equivalents), bonds (fixed income), and stocks (equities).
- Cash (including "cash equivalents") investments are generally considered "safe" and allow easy access to principal and interest without a withdrawal penalty. Examples include bank accounts and money market funds.
- Bonds, known as fixed income investments, are issued by companies or governments. Bond investors are essentially lending the issuer money and the issuer promises to pay back the debt with interest by a certain date. Corporate bonds are considered "riskier" than cash investments because their value may fluctuate with market interest rates, and there is a risk the issuer may not be able to pay back the debt.
- Stocks, also called equities or "company shares," are issued by companies. Stock investors are buying an ownership share in the company. Stocks are considered "riskier" than bonds because the market value of shares may fluctuate daily and, as part-owners, investors share in the company's business risks.
You can purchase and manage your own individual investments, if you wish. But for some investors - especially beginning investors - it is easier to rely on the professional management expertise available through mutual funds or variable annuities.
- Mutual funds are professionally managed investment portfolios. Fund managers pool money from individual investors and use it to buy and manage a diversified investment portfolio on their behalf. Mutual funds may concentrate on cash equivalents, fixed income, equities, or some combination of asset classes.
- Variable annuities are contracts issued by an insurance company and are long-term tax-deferred vehicles designed for retirement purposes. They offer three main benefits: Tax-deferred treatment of earnings, guaranteed death benefit options, and guaranteed lifetime payout options.
Developing your investment strategy
Below are three basic steps to developing a long-term investment strategy:
- First, determine the specific goal, or investment objective, that reflects your desires and intentions.
- Second, identify your risk tolerance, which is simply your personal ability to withstand - both financially and emotionally - the risk that your investments may lose money.
- Third, choose an appropriate investment mix, or asset allocation, that both supports your investment objective and reflects your personal risk tolerance.
A qualified financial professional can guide you through each of these steps.
Other considerations for investing
Here are a few other things to be aware of in order to become an informed investor:
- Specific investment risks. Make sure you understand the risks of the specific products and/or investments you are interested in.
- Diversification. One of the best ways to manage risk and help increase the potential for higher returns over time is to divide your investment dollars among investments that carry different types of risks; for example, stocks can often behave differently than bonds in the same market conditions, so having a mixture of both can help reduce overall risk.
- Portfolio rebalancing. Over time, a portfolio's original investment mix (the percentage allocated to each investment) can change dramatically due to gains and losses. Periodic rebalancing to restore the original percentages can help keep your investment strategy on track.
- Charges and expenses. Familiarize yourself with any charges or expenses associated with your investments. Mutual funds, for example, charge a professional money management fee, typically an annual percentage of the value of your investment in the fund.
- Tax implications. Tax treatment can have a big impact on your overall return, yet it can be one of the most confusing aspects of investing. When in doubt, ask a qualified tax professional.
What is risk tolerance?
When it comes to developing a plan for achieving your financial goals, risk tolerance is one of the first - and most important - concepts you must understand and apply to your financial planning.
"Risk tolerance" is simply your personal ability to withstand - both financially and emotionally - the risk that your investments may lose money.
The concept of risk tolerance is important because there is a fundamental relationship between investment risk and reward, as illustrated in the chart to the right:
"Risk" refers to the frequency and degree to which an investment's value may fluctuate up and down over time (known as "volatility"). "Reward" refers to the expected level of return available from an investment. Generally, the safer an investment is (or the lower its volatility), the lower its expected return. Conversely, the riskier the investment (or the greater its volatility), the higher its potential return.
Two dimensions of risk tolerance
Two dimensions of risk tolerance to consider are: financial and emotional.
The financial dimension of risk tolerance is more objective and refers to the "time horizon" of your investment goals. Generally speaking, if you will need the money from an investment within five years, your time horizon is short-term and you should consider more conservative (or "safer") investments.
If your time horizon is greater than five years, you can consider more aggressive (or "riskier") investments that offer a higher potential return. Longer-term time horizons generally mean investors are financially prepared to withstand an investment's poor short-term performance because there is still the potential for achieving a higher average return over time.
The emotional dimension of risk tolerance is more subjective and depends upon your personal attitudes about money, and your reaction to the likelihood of losing money. For example:
- If it would cause you a great deal of stress to lose money in an investment in the short-term, you probably have a low tolerance for risk.
- If short-term loss in an investment's value isn't a great concern for you, you probably have a higher tolerance for risk.
What is your personal risk tolerance?
Your personal risk tolerance is simply your own individual balance point between the financial and emotional dimensions of risk tolerance. Identifying this balance, while keeping your own financial goals in mind, is central to the development of an effective overall investment strategy. Your financial professional should work closely with you throughout this process.
Managing your risk
As you can probably tell by now, "risk" is not necessarily a bad thing. As a vital part of the risk/reward dynamic, it may be necessary to achieve your investment objectives - particularly long-term objectives. Successful investing is not necessarily about avoiding risk; it's about managing it properly.
Determining your personal risk tolerance with the help of your financial professional is the first step to managing risk properly, but there are other important steps you can take as well. Here are a few risk management topics that you can discuss with your financial professional:
- Specific investment risks: Make sure you understand the risks of the specific products and/or investments recommended by your financial professional.
- Diversification: One of the best ways to manage long-term risk is to divide your investment dollars among different types of investments which carry different types of risks. For example, stocks often behave differently than bonds in the same market conditions, so having a mixture of both can help reduce overall risk.
- Portfolio rebalancing: Over time, a diversified investment mix can change dramatically due to investment gains and losses. Periodic rebalancing to restore the original portfolio mix can help keep your investment strategy on track.
- Dollar-cost averaging: Allows for gradual investment over time, systematically buying more units when prices are low and fewer units when prices are high. This can potentially lower the average cost of variable units. Dollar cost averaging results in the purchase of more units when the unit value is low, and fewer units when the unit value is high. However, there is no guarantee that the dollar cost averaging program will result in higher policy values or will otherwise be successful. Dollar cost averaging requires regular investing regardless of fluctuating prices and does not guarantee profits nor prevent losses in a declining market. Before electing this option, you should consider your financial ability to continue transfers through periods of both high and low price levels. Amounts allocated to the subaccount of the separate account are subject to investment risk including possible loss of principal.