7.1 Investment Principles and Concepts - 7.1 Investment Principles and Concepts Explained
Key Concepts
- Time Value of Money
- Risk and Return
- Diversification
- Asset Allocation
- Market Efficiency
- Rebalancing
- Costs and Fees
Time Value of Money
The Time Value of Money (TVM) principle states that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This concept is crucial for making informed investment decisions and understanding the impact of interest rates and inflation.
For example, if you invest $1,000 today at a 5% annual interest rate, it will grow to $1,050 in one year. Over time, this compounding effect can significantly increase the value of your investment.
Think of TVM as planting a seed today that grows into a tree over time, providing more value than the seed alone.
Risk and Return
The Risk and Return principle highlights the relationship between the level of risk an investor is willing to take and the potential return on investment. Generally, higher risk investments offer the possibility of higher returns, but they also carry a greater chance of loss.
For instance, investing in stocks typically offers higher returns than bonds, but stocks are also more volatile and can experience significant price fluctuations.
Consider risk and return as a seesaw. To achieve higher returns, you must be willing to balance on the riskier side.
Diversification
Diversification is the strategy of spreading investments across various asset classes, sectors, and geographic regions to reduce risk. By diversifying, investors can minimize the impact of poor performance in any single investment.
For example, instead of putting all your money into one stock, you could invest in a mix of stocks, bonds, real estate, and commodities.
Think of diversification as a basket of different fruits. If one type of fruit spoils, the others remain fresh and provide sustenance.
Asset Allocation
Asset Allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The allocation is based on factors like risk tolerance, investment goals, and time horizon.
For instance, a young investor with a long time horizon might allocate 80% of their portfolio to stocks for growth, while a retiree might allocate 60% to bonds for stability.
Consider asset allocation as a recipe. Different ingredients (assets) are combined in specific proportions to create a balanced and satisfying dish (portfolio).
Market Efficiency
Market Efficiency refers to the degree to which stock prices reflect all available information. In an efficient market, prices adjust rapidly to new information, making it difficult for investors to consistently outperform the market.
For example, if a company announces strong earnings, its stock price will likely rise quickly, reflecting the positive news.
Think of market efficiency as a well-informed crowd. Any new information is quickly absorbed and reflected in prices, making it hard to find undervalued opportunities.
Rebalancing
Rebalancing is the process of adjusting the proportions of assets in a portfolio to maintain the desired level of risk and return. This is necessary because asset values fluctuate over time, potentially altering the original allocation.
For example, if your portfolio was initially 60% stocks and 40% bonds, but stocks have performed well, the stock portion might grow to 70%. Rebalancing would involve selling some stocks and buying bonds to restore the original 60/40 split.
Consider rebalancing as a gardener pruning a tree. Regular trimming ensures the tree stays healthy and maintains its desired shape.
Costs and Fees
Costs and fees associated with investments, such as management fees, trading costs, and taxes, can significantly impact returns. Understanding and minimizing these costs is essential for maximizing investment performance.
For instance, a mutual fund with a 1% annual management fee might reduce your overall return by 1% each year, which can add up over time.
Think of costs and fees as hidden drains on a water tank. Even small leaks can deplete the tank over time, so it's important to identify and fix them.