Markets

1 Thing You Must Know Before Investing Any Money

Before you invest, the first question that probably comes to your mind is whether or not it's a good investment. Or maybe you wonder how much money you could make.

While these are great questions, they aren't the most important ones. Instead, start your investing journey by asking these things.

Two signs stacked on top of each other that say risk and reward.

Image source: Getty Images

Can you take risks?

By examining your risk tolerance, you'll learn how much volatility you're comfortable with. And part of this will involve looking at your risk-taking ability. How old are you? How long do you have until you'll use your money? How stable is your income?

Stock market crashes don't happen often and historically have been followed by bull markets. But if you lose 30% or 40% of your account value, it could take you years before you regain it.

The table below shows how much you would've lost during the dotcom crash that occurred between 2000 through 2002 and the Great Recession of 2008 if you invested $100,000. It also shows how long it would've taken before you got back to your original $100,000 -- assuming you didn't sell..

Initial $100,000 Investment Before: After Losses Year 1 Year 2 Year 3 Year 4 Year 5
Dotcom $57,000 $73,000 $81,000 $85,000 $99,000 $104,000
Great Recession $63,000 $80,000 $92,000 $93,500 $108,500 $144,000

Calculations by author.

This is why the longer you have before you need your money, the more aggressive your accounts can be. And the closer your need, the more conservative your investments should be. While you may feel completely fine with risk, if you have an important goal in a year or two, like retirement, too much volatility could derail your plans.

Do you want to take risks?

Other questions will look at your risk-taking willingness. During a previous stock market crash, how did you feel? How did you react? Do you prefer stable and predictable investments, or will you take a gamble on something that could either win or lose big?

Typically, the bigger the potential reward, the bigger the possible losses. And it's for this reason you shouldn't pick investments based solely on how much they could gain unless you feel equally comfortable with how much they could lose. The table below shows average rates of return, as well as best years and worst years for various asset classes.

100% Bonds 30% Stocks/70% Bonds 50% Stocks/50% Bonds 70% Stocks/30% Bonds 100% Stocks
Average rate of return 6.1% 7.7% 8.7% 9.4% 10.3%
Best year 45.5% 38.3% 33.5% 41.1% 54.2%
Worst year -8.1% -14.2% -22.5% -30.7% -43.1%

Data source: Vanguard. Based on data from 1926 to 2020.

Investing in 100% stocks may seem great in a year when you grow your accounts by 54%. But if you can't also withstand a year where you could lose 43% of your account values, this asset allocation model may not be appropriate for you. Instead, a more conservative one could give you better peace of mind and help you stay invested more consistently.

Time in the market over timing the market

If you can time a market bottom perfectly, you could make a lot of money. But you can't, so you shouldn't expect maximum returns. Moreover, the longer your money stayed uninvested, the lower your return could be.

You may have the idea of taking on a lot of risk when the stock market is doing great and reducing it when it's doing badly. But extreme accuracy would matter, and unless you have a crystal ball, it might be very hard. That's why this type of market timing may not be the best idea. Instead, you should choose an asset allocation model and stick with it through all market cycles.

It's important that you research and choose good investments. But even more vital is that you pick investments that are right for you and your risk tolerance. Doing so can help make your investing experience more enjoyable and your path to your goal a smoother ride.

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