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Investment strategy: Everything you need to know

At a glance:

  • Investment goals and strategy

  • Economic factors

  • Investment risk

  • Investment taxes

  • Trading securities

  • Summary of investment strategy

  • Practical ideas you can start with today

What are the right investments for you? How do you build a portfolio that makes your money perform the way you need it to? Before you invest, you need an investment strategy that will guide your decisions and determine how you will assess your results.

There are several aspects to investment strategy, including the overall economy, risk, taxes, and more. Your investment strategy should also be aligned to your investment goals.

A trader works at the Egyptian stock exchange in Cairo, Egypt, March 8, 2016. Stock markets in the Gulf may firm on Tuesday as investors could be encouraged to enter longer-term positions with further evidence that oil prices may have bottomed. Egypt may be supported by positive earnings from Telecom Egypt. REUTERS/Mohamed Abd El Ghany
A trader at the Egyptian stock exchange in Cairo, Egypt, March 8, 2016. (Photo: REUTERS/Mohamed Abd El Ghany)

Investment goals and strategy

Ready to start investing? How will you choose from among the thousands of investment opportunities available? The best first step is to decide what kinds of benefits you want your investments to provide.

Once you've set goals for how you want your investments to perform, you can assess the features of various investments to determine whether they meet your needs.

Here are some basic investment goals. It is important to remember that these goals aren't mutually exclusive. You may put together an investment portfolio that combines a number of these benefits.

Growth and income

Investments can make money for you in two basic ways. They may pay you regular income in the form of interest payments or dividends. They may also grow in value, permitting you to sell them for more than you paid for them. Attempting to maximize the income from investments is an income strategy. Trying to maximize the growth in value, or capital appreciation, of investments is called a growth strategy.

Some investments offer only one benefit or the other. Bonds, for instance, provide interest income but don't typically grow in underlying value. Some stocks pay no dividend income, their companies reinvest their earnings for future growth. Other stocks provide both income and growth potential. It is possible to blend both growth and income goals in one portfolio.

Inflation protection

Even in good economic times, inflation rolls on, eating away the value of assets. One investment goal is to look for investments that are likely to outperform the inflation rate. Of course, the higher the potential rate of return, the more risky the particular investment is apt to be.

Liquidity

Liquidity refers to how easy it is to convert an investment into cash, or to withdraw funds from it, usually with little or no loss in value. Generally speaking, the more liquid and stable an investment, the lower its rate of return. If you cannot afford to do without the use of your principal, your portfolio may need to trade rate of return for greater liquidity.

Preservation of principal

It is possible for an investment to be very liquid, yet subject to market value decline. A good example of this is a stock mutual fund. When your desire is to maintain the original value of your investment with little or no risk of loss, you then have a goal of preservation of principal.

Loan security

Even if you won't need to spend your principal, you may need it to use as collateral, i.e., security for a loan. Some investments can be used as collateral, and some — options and futures, for instance — cannot.

Since your investment goals will determine the objectives of the investments in your portfolio, it pays to think carefully about exactly what you want your investments to achieve.

Economic factors

While there are many things you can control about your investment strategy, one thing you can't control is how trends in the general economy will affect the performance and value of your investments.

Neither can you make completely reliable predictions about what those trends will be. But general economic trends drive the performance of investments, so you have to make some determination to guide your decisions — and take precautions to minimize risk if you decide wrong.

Inflation

Inflation is the term for rising prices, generally driven by a greater demand for goods and services compared to the supply: "too much money chasing too few goods." Inflation is likely to be with us always. The question is, what will inflation rates do?

This impacts more than simply the need for investments to outperform the inflation rate in order to show real gains in value. Anticipation about inflation trends also spurs the Federal Reserve to raise or lower interest rates, which impact the relative value of many kinds of securities.

Interest rates

Interest is the cost of borrowing money, and when you lend a company or government money by buying a bond or other debt instrument, the cost it pays is the income you make. By changing the interest rate it charges for loans, the Federal Reserve controls interest rates throughout the economy. And changing interest rates have a direct impact on the value of debt securities like bonds.

When interest rates rise, bonds, most of which pay fixed rates of interest, are less valuable to investors, and when interest rates go down, the value of bonds goes up. Your choice of debt securities — and the amount of debt securities in your portfolio compared to other investments like stocks — will depend in part on where you think interest rates are going.

Business trends

Will a high-tech boom continue? Will falling consumer confidence lead to a decline in retail sales? Will a new industry grow or disappear? Trends in a particular area of business affect the performance of the companies that participate in that business — which in turn affects the economy as a whole.

Business trends affect investment strategy in two main ways. Savvy investors want to take advantage of business trends to invest in growing businesses and stay away from those that may decline. Prudent investors diversify their portfolios to keep any one business trend from having too great an impact on their investments.

Your prediction about changes in these factors will have an influence on how you build your investment portfolio. And as economic factors change, the portfolio of a savvy investor changes along with them.

Investment risk

Risk, in traditional terms, is the relative likelihood that your investment will either lose money or fail to earn it. "Great," you say, "I want to stay away from risk in my investment strategy." Not that easy, unfortunately. The return on investment is the lure companies or governments use to get people to give them money, so the greater the risk, the greater the potential return. This phenomenon is known as the risk premium.

Conversely, low-risk investments tend to provide lower returns. There are many kinds of risk, but three basic risk considerations govern investment strategies:

Safety of principal

Will you be able to at least get out of an investment what you put into it? If you are in a position to risk your principal, you have the ability to take advantage of investments with potentially high returns, like volatile stocks or high-yield corporate bonds. If you are a few years away from retirement and you need that money to live on, you may want to choose investments in which your principal is safer.

Some investments, such as fixed annuities, guarantee your principal (based on the financial strength and claims-paying ability of the issuing insurance company, loss of principal is still possible). Others, such as US Treasury bonds, are backed by such formidable credit that your principal might as well be guaranteed.

Learn more about the risks of US Treasury bonds.

Reliability of income

If you need regular income to live on, repay loans or reinvest, you will want to choose securities that provide reliable income, such as investment-grade bonds or blue chip stocks. Reliable income, however, usually comes at the expense of large returns and growth potential.

Preservation of purchasing power

Traditionally, we describe risk in the terms discussed above. However, there is also another issues to consider. You may have more dollars in the future than you have today, but can those dollars purchase the same quantity and quality of goods and services as today?

We're talking about the impact of inflation, and when considering a long time horizon, the impact can be as devastating as a market crash. Does the after-tax rate of return of your investment exceed the rate of inflation? You may have to trade off safety of principal to preserve purchasing power.

A good investment strategy is risk-averse. In other words, it seeks to get the greatest return with the least risk possible. You have to determine your own risk tolerance: how much risk you can afford to take on as you seek to get the best return.

Investment taxes

Whether they pay regular interest or whether you cash them in, investments add to your income, which can add to your tax burden. The taxation of investment gains can be an extremely complex subject, and the more complicated your portfolio, the more likely it is that you will need expert tax advice. Here are a few basic things to be aware of.

Capital gains or not?

In order to encourage investment, the government taxes capital gains at a lower rate if you hold them for a certain period. But not all accrued value is capital gains. For instance, even though you might buy a zero coupon bond at a discount and redeem it for much more money, the increased value is interest, not capital gains, and is usually taxed as regular income.

Tax breaks

Some investments, especially investments in retirement plans and accounts, provide several ways to shelter your money from taxation. Tax-deferred investments allow funds to build up without incurring immediate tax liability in your investment. You pay taxes on your earnings only when you take them out as cash. Other plans permit pre-tax investment, i.e., the amount of your income you invest is not subject to tax. Still others permit you to deduct a portion of your invested funds from your income for tax purposes.

Regulations

Knowing the current state of the tax code regarding investment earnings is a full-time job. With some investments, you must pay tax on your earnings, even though you can't use them as income. In some instances, a portion of your earnings will be taxed one way, another portion in a different way. Unless you want to spend lots of time reading IRS publications, you should plan to get expert advice — advice you will have to pay for and factor into the cost of your investments.

Making the right tax strategy decisions can keep you or your heirs from losing a significant portion of your investment value to taxes unnecessarily.

Trading securities

Buying and selling securities and other investments isn't as easy as picking up a basket of groceries. How investment instruments are bought and sold and how much work goes into tracking their value are important strategic considerations as you invest.

Buying and selling

Will you have to work through a broker, and what kind? Full-service brokers provide investment counseling and research along with executing trades in different kinds of securities. Discount brokers, including many of the online brokerage services, simply execute your trade. As the name implies, discount brokers take less of your investment dollars in fees and commissions, which may be an attractive benefit if you can do the work of researching investments yourself.

Minimum investment

Many kinds of investment instruments have minimum investments — from the $500 minimum balance you need for a money market savings account to the $10,000 you need to get started in many corporate bond issues. Mutual funds can be more flexible, but most of these require you to make minimum investments as well.

Fees and charges

Even discount brokerages charge fees and commissions for processing your trades. Investing in financial products such as mutual funds and variable annuities may involve sales and distribution costs known as loads. These products are likely to also have investment management fees and administration costs. When using insurance products as investments, you must also consider the costs of insurance. And many kinds of tax-deferred investments involve fees as well as tax penalties for early withdrawal.

Maturation

Debt securities like bonds repay your principal upon a certain date on which they are said to mature. Maturity periods can be decades long. Even if you can sell your security before it matures, the length of time before maturity will have an impact on how easy it is to sell and how much you will get for it.

Tracking value

How will you know how your investments are doing? For stocks and many mutual funds, the answer can be as easy as picking up the newspaper or subscribing to an online investment information service. Others may involve extra work, like researching a company's bond rating or performing calculations to determine the lifetime value of a bond issue. How much effort you want to put into tracking value may determine which investment choices you are comfortable with.

As you can see, one of the first strategic considerations you need to make is whether you have the knowledge, energy, or inclination to execute a detailed investment strategy, or whether you'd prefer to have someone else — like an investment advisor — do all the strategizing while you relax and wait for the quarterly reports.

Summary of investment strategy

A well-crafted investment strategy takes many things into account: economic factors, risk considerations, trading and taxation features, and, of course, your own investment goals.

One of the first strategic considerations you need to make is whether you have the energy or inclination to build and execute a detailed investment strategy, or whether you would prefer to have someone else — like the manager of a mutual fund — do all the strategizing while you relax and wait for the quarterly reports.

Practical ideas you can start with today

  • List your investment goals.

  • Determine your time horizon for investing.

  • Determine your risk tolerance.

  • Determine how much money you can comfortably set aside to invest.

  • Choose investments that provide growth or current income, or a combination of both.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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