The Basics of Selecting Investments

By FINRA Staff Markets Fool.com

Whether you decide to use an investment professional or not, it's important to understand what your investment choices are and how different types of investments put your money to work. It's equally important to understand yourself as an investor. That's because a portfolio that's right for someone else may not be best for you.

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Some factors that can make a difference in your investment selection are your goals, or what you want to accomplish by investing, and the time frames for meeting those goals. It's also important to have a handle on your attitude toward risk, or what's called your risk tolerance.

No single approach to choosing investments will work for everyone or will be right for every situation. But here are a few tried-and-true rules for sound investment selection.

Image source: Getty Images.

Understand what you own.Focus on investments that are easy for you to evaluate and give you access to reliable information about them. Regulators require that certain information be disclosed to investors through documents such as offering circulars, mutual fund prospectuses, and corporate filings for stock issued by public companies that trade on the major stock markets. In addition, you can find a wealth of real-time and historical market data for stocks, bonds, mutual funds, and other securitiesonline.

Assess liquidity.Make sure there is a market to trade your investments. Highly liquid investments are easy to buy and sell, either through a brokerage account or in some cases directly from the issuer. Thinly traded stocks or securities that aren't listed on a national securities exchange tend to be less liquid -- and are rarely a good idea for most investors. Likewise, exercise caution when considering securities such as non-traded REITs that may be illiquid -- meaning you can't cash out of them even if you really need do -- for long periods of time.

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Know the true cost.Have a clear understanding of any costs, sales charges, and fees involved with buying and selling investment products, including whether there are penalties or additional fees for selling your investment within a certain time frame.

Comparison shop.Costs and services can vary significantly from firm to firm.

Verify registration.Check whether your investments are registered with the SEC or your state's securities regulator. Most investments have to be. And also use FINRABrokerCheckto check whether the salespeople who sell them are licensed.

Understanding risk is key

When you select any investment product, it's vital to understand that all investments carry some level ofrisk. Stocks, bonds, mutual funds, and exchange-traded funds (ETFs) can lose value -- even all their value -- if market conditions sour. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk; they may not earn enough over time to keep pace with the increasing cost of living. Whatever investment you're considering, be sure you know how it can make or lose money before you buy.

Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare. For example, your investment value might rise or fall because of market conditions (market risk). Corporate decisions, such as whether to expand into a new area of business or merge with another company, can also affect the value of your investments (business risk). If you own an international investment, events within that country can affect your investment (political risk and currency risk, to name two).

There are other types of risk to consider. How easy or hard it is to cash out of an investment when you need to is called liquidity risk. Another risk factor is tied to how many or how few investments you hold. Generally speaking, the more financial eggs you have in one basket (say, all your money in a single stock), the greater risk you take (concentration risk).

Time frames and investment selection

For every financial goal you set, think about the time frame in which you might need the money you have invested. For near-term goals, you'll want to consider moving some or all of your portfolio into liquid, lower-volatility investments such as short-term bonds, certificates of deposit, and cash.

For longer-term goals, stocks and mutual funds that invest in stocks have the potential to provide higher returns. Based on historical data, holding a broad portfolio of stocks over an extended period of time (for instance, a large-cap portfolio like the S&P 500 over a 20-year period) significantly reduces your chances of losing your principal. However, the historical data should not mislead investors into thinking that there is no risk in investing in stocks over a long period of time.

For example, suppose an investor invests $10,000 in a broadly diversified stock portfolio and 19 years later sees that portfolio grow to $20,000. The following year, the investor's portfolio loses 20% of its value, or $4,000, during a market downturn. As a result, at the end of a 20-year period, the investor ends up with a $16,000 portfolio, rather than the $20,000 portfolio she held after 19 years. Money was made -- but not as much as would have been made if shares were sold the previous year. That's why stocks are always risky investments, even over the long term. They don't necessarily get safer the longer you hold them.

This is not a hypothetical risk. If you had planned to retire during the financial crisis of 2008 and 2009 -- when stock prices dropped by 57% -- and had the bulk of your retirement savings in stocks or stock mutual funds, then you might have had to reconsider your retirement plan.

Investors should also consider how realistic it will be for them to ride out the ups and downs of the market over the long term. Will you have to sell stocks during an economic downturn to fill the gap caused by a job loss? Will you sell investments to pay for medical care or a child's college education? Predictable and unpredictable life events might make it difficult for some investors to stay invested in stocks over an extended period of time.

The bottom line: At every stage of your investing life, the more carefully you plan and the more informed the investment decisions you make, the better the chances you'll have of meeting all of your investment goals and achieving a secure financial future.

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