Individuals who are completely new to investing pose a common question: Where does one start? This archive article from the August 1988 issue of the AAII Journal answers the question with a clear explanation of basic investing concepts.

“Why don’t you ever write any articles for widows?”

That plea has been heard a number of times, and it is usually met with some surprise on my part. After all, AAII Journal articles are aimed at the different needs of various investors, and not at sociological classifications. For instance, some articles are aimed at individuals who need high income and low-risk investments, while others are aimed at those who need aggressive growth vehicles. Presumably, different widows have different investment needs.

Nonetheless, there apparently is a perceived void, which this article will briefly try to fill even at the risk of sounding somewhat sexist.

Do all widows have similar investment needs? No—investment needs are a function of too many diverse characteristics, such as current and future sources of income, tax status and an individual’s own risk tolerance. I suspect, however, that there is a common denominator: Suddenly, these women have been thrust into a situation in which important decisions must be made regarding large sums of money or investment holdings, and they may have little knowledge on which to base those decisions. Where do you start? Of course, this is not limited to widows—many others, including men, may find themselves in this kind of situation.

This article is really aimed, then, at those individuals with little investment knowledge, who are thrown into deep financial waters and are told to sink or swim. It won’t tell you what to do; instead, it is an overview that should provide you with a base on which to make your own investment decisions.

Where to Start: The Basics

Where does one start when they know absolutely nothing about investing? I’ll assume that the preliminary work has been done, such as budgeting and gathering information on current wealth. These are not insignificant tasks. However, here we’re concerned with an investment problem.

The first step is to learn some basic investment concepts. You should understand these concepts whether you go on to do your own investing, or whether you decide to turn to an adviser for help.

The most basic concept is very straightforward: Never invest in anything that you do not understand. If this means that you are restricted to certificates of deposit (in banks that are insured), then so be it.

Other important concepts are somewhat more complex: risk, the risk-return relationship and the importance of diversification.

Basic Concepts: Risk

Many investors, when viewing investment alternatives, focus on potential returns. Equally important, however, is risk. All investments carry some risk.

What is risk? It can best be defined as uncertainty—of not knowing what is going to happen to your investment. There are different ways of viewing this uncertainty risk; you should be aware of all of them when comparing investments. These include:

• The risk of not getting the return you expected. In the worst instances, this would include losing some or all of your original investment.
  
• The risk of not being able to get out of the investment at any time with the original investment amount intact. This is also known as liquidity risk, and it can occur either because the market is not active (for instance, it takes some time to sell a house) or because the market is very volatile (and you may have to sell at a significant loss).
  
• The risk of bankruptcy or default of the business in which you are investing. This affects not just the holders of stocks, but also bondholders and those who purchase certificates of deposit from banks that are not federally insured.
  
• The risk of not keeping up with inflation. This risk is often ignored. However, if your assets are earning less than the inflation rate, you are losing ground—your investment will not be able to buy as much in the future as it can today.
  
• The risk of being forced to increase your commitment in order to maintain the investment. Some investments, such as futures, options, those that use margin and some limited partnerships, hold you liable for more than what you put up initially. These are extremely risky and should be avoided, particularly by those new to investing.
  

The Risk-Return Trade-Off

An important element of risk is its relationship to return. This relationship exists on average, and not in every single instance. On average, the returns from an investment should compensate for the level of risk undertaken: Riskier investments can be expected to have higher returns, and low-risk investments can be expected to have lower returns. In order to earn a higher return, you must take on more risk, and in order to have low risks, you must accept lower returns. That’s why low-risk investments—money market funds and money market deposit accounts—have lower long-term returns on average than higher-risk investments, such as longer-term bonds (with moderate risk and somewhat higher expected returns) and stocks (moderate to high risk and higher expected returns).

Sometimes, riskier investments will not produce higher returns—these are “inefficient” investments (they are also lousy investments). The converse rarely occurs—low-risk investments do not produce high returns; any claims that an investment will produce high returns at low risk is hype and should be viewed skeptically. The important point is that you should always look at both returns and risk when comparing investments: If you are considering two investments, for instance, and one has a slightly higher expected return but is much riskier, it is not as desirable.

In order to judge the risk-return trade-off, you must have some idea of what kinds of returns to expect. Ideally, you are seeking the highest return for the level of risk you have decided that you can stomach. But your expectations should mesh with reality.

Most expectations are based on what happened in the past and, unfortunately, history doesn’t always repeat itself. On the other hand, there is little else to go on, and reasonable conclusions about future returns can be reached by looking at the past, with the understanding that these returns are not guaranteed.

During the 30-year period ending in 1988, stocks produced returns that average between 10% to 14% annually; long-term bonds produced average annual returns of between 6% to 10% and money market funds averaged 6% to 9% annually [for the period of 1988–2017, the returns are 10% for stocks and 8% for bonds]. These returns reflect the risk-return trade-off: higher-risk stocks tend to do better than medium-risk bonds, which tend to do better than low-risk money market funds.

You should not expect returns much higher than these for the various investment categories. In fact, your actual returns will probably be somewhat lower, because you will incur transaction costs (such as sales commissions and other fees), and you will have to pay taxes on income and gains. Cost considerations should not override investment decisions, but you should keep a keen eye on them. The bulk of these costs are incurred only when you make a transaction; the fewer changes you make, the lower your costs.

Basic Concepts: Diversification

Another extremely important investment concept is diversification. In fact, it is related to the risk-return concept. Numerous studies have shown that the best returns at a given risk level are achieved through diversification—being invested in more than one investment category (for instance, stock, bonds and cash). It is also important to be diversified within most investment categories—in the stock category, for instance, this consists of investing in 10 unrelated stocks rather than just one.

The reason why diversification is so important is more complicated than the notion of simply not putting all of one’s eggs in one basket, and it is well worth understanding the reason.

Diversification is an important part of the risk-return relationship. Returns compensate for risk, but they do not compensate for all risk. Diversification eliminates those risks that are not compensated for through greater returns. For example, if you invest in only one bond, you face a significant default risk: If your one bond defaults, you will suffer a substantial loss. However, if you invest in a large number of bonds, a single default will have considerably less impact, and your return for the group will be similar to that of a single bond that did not default. Another example would be if you put all of your assets in a savings account. This is generally considered to be very low risk, and it is. But it does have one kind of risk—the risk that those assets will not keep up with inflation. That inflation risk can be reduced by diversifying into other asset categories—for instance, by putting a small amount in common stock mutual funds—and over the long term your average return will not be lowered.

The importance of diversification can be seen by restating it in the negative: If you don’t diversify, you are taking on a considerable risk for which you will not be compensated.

There is another type of diversification that is also extremely important, yet it is frequently ignored. It is known as time diversification—remaining invested over different market cycles. “Time heals all wounds”—including investment wounds. Remaining invested over longer time periods substantially reduces the risk that, at the end of your investment period, you will not have earned the return that could be expected based on the risk that you took.

The stock market provides the best example of the benefits of time diversification. In the stock market, investors face the substantial risk that their investments will suffer an actual loss in value. However, as the length of time invested in the stock market is increased, the risk of suffering a loss is substantially reduced. Since World War II [through 1988], investors who remained in the market for only one year could have suffered a loss of as much as 26.5% of the value of their assets; their chances of seeing a loss were also greater, since there were 10 one-year time periods in which the stock market suffered a loss. In contrast, investors who remained in the market for 10 years on average faced no risk of an actual loss to their portfolio.

Time diversification has much more of an impact on investments that have a high degree of volatility, such as stocks, where prices can fluctuate wildly over the short term; longer time periods smooth those fluctuations. Time diversification is less important for relatively stable investments, such as certificates of deposit, money market funds and short-term bonds. That’s why these investments are usually recommended for investors who plan on remaining invested only for short time periods (less than five years); you should not be invested in the stock market or other risky investments if you plan on remaining invested for less than five years. This is a sound approach for short-term investors even if it is undertaken at the expense of diversification across investment categories—if, for instance, you must exclude stocks.

One other aspect of time diversification comes into play when investing or withdrawing large sums of money. In general, it is better to do so gradually over time, rather than doing so all at once. This process is known as dollar cost averaging withdrawals.

Concentrating Your Efforts

It is traditional, after laying the groundwork, to survey the investment media, such as stocks, bonds, insurance investments, etc. Many investment books do this quite well, and it is certainly important to have a general understanding of these categories, particularly in terms of the risks and returns you can expect. However, individuals who are new to investing should be careful about spending too much time (and money) trying to master investments that are too complex to start with. Which investments are these?

• Individual stocks and bonds
  
• Insurance investment products (whole and universal life, for instance; this does not include straight insurance, such as term, which is not an investment)
  
• Futures, options and margined investments
  
• Limited partnerships
  

Limited partnerships and insurance investment products are extremely difficult to analyze. In general, the terms of the contracts are complex and vary considerably; comparisons among products are difficult.

Futures, options and margined investments are very risky—most likely beyond the risk that most individuals can tolerate, particularly newcomers.

Picking individual stocks and bonds can also be tough. First, the group of stocks or bonds chosen must be diversified. Second, you could spend years trying to learn all of the various techniques that are espoused for selecting the “right” stock or bond.

Instead, newer investors should be concentrating their efforts on no-load mutual funds. These funds are a low-cost way of tapping into professional investment advice, and provide investors with a full array of investment categories, including stock funds, bond funds and money market funds. AAII’s annual “Guide to the Top Mutual Funds” is the single best source of information for investing in these funds.

The Next Step: Asset Allocation

Once an investor understands the concepts, the next step is applying them to individual circumstances. That means determining what portions of your wealth are invested in the various investment categories. This is known as asset allocation, and it is the single most important investment decision you will make. It has far more of an impact on long-term future returns than such decisions as individual stock picks, assuming you are properly diversified.

Unfortunately, it is difficult to come up with generalizations that can be applied to asset allocation. The decision has to be made by the individual, because it is based on personal circumstances, such as income needs, time horizon and the amount of risk the individual is willing to take on. However, you should be diversified among the various investment categories: stocks, bonds, cash and real estate (including your own home). One simple approach (which excludes your home from the calculation) would be to put a minimum of 25% in each of three categories: stock mutual funds, bond mutual funds and money market funds, and to apportion the remainder according to your risk and return preferences; if you are conservative, you would apportion the remainder to money market funds and bond funds.

The specific kinds of mutual funds chosen depends not only on your own risk-return trade-off, but also on your income needs and tax stance. If you need income, you may want to consider for your stock portion those funds that invest in conservative, high-dividend-paying stocks; if you are in a high tax bracket, you may want to consider municipal bond funds for your bond portion. Beware, however, when choosing among bond funds, whether municipal or taxable: The longer the maturity of a bond, the greater the risk. Long-term bonds with maturities of 20 years or more have risk levels approaching the risk of stocks. When choosing bond funds, stick to the shorter maturity funds—those with less than five years’ maturity.

Asset allocation is complex—it could be the subject of numerous articles. Any asset allocation decision, however, should be based on the investment concepts discussed here.

Finding Shallower Waters

The investment concepts outlined here, along with the reference material, should provide you with a base—a life preserver, so to speak. With time, as you gain more knowledge and become more accustomed to the waters, perhaps they won’t seem quite so deep.