Risk is an unavoidable part of investing, and there are costs involved. Understanding your costs and knowing how to plan for risk are critical steps in your investing journey.
What can I do to manage risk?
You can manage some of the risk of investing in two ways:
- Buy more than one type of fund (also known as diversifying).
- Buy and sell in regular dollar amounts over time (called “dollar-cost averaging”) instead of all at once.
Diversifying, or spreading your money across different types of investments, works because different types of investments perform differently. For example, bond funds might lose some value when interest rates rise, but stock funds might benefit from that change. If you diversify and one of your funds goes down, there’s a good chance another fund will partly offset that decline.
One risk everyone wants to avoid is buying high or selling low. The best way to do this is to break your purchase (or sale) into several smaller, equally sized chunks rather than buying (or selling) all at once — for example, five monthly $200 purchases rather than a single $1,000 purchase. Investing this way averages the price of shares you are buying and selling, which is why it is called dollar-cost averaging.
Want to learn more? Read about Handling Investment Risk.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. The application of dollar-cost averaging provides you with the opportunity to reduce but not eliminate investment risk and potentially maximize return by allocating investable monies over a period of time. Dollar-cost averaging cannot guarantee a gain or protect against a loss in a declining market. Because dollar-cost averaging involves continuous investment in securities, regardless of their changing price levels, you should consider your financial ability to maintain the program over the long term.
Isn’t it safer not to invest at all?
Not investing is surprisingly risky. While most people don’t think about it, your money becomes less valuable every day because of inflation. Typically, interest earned in bank savings accounts doesn’t keep up with inflation either. So years from now, maybe after you retire, the prices on the things you buy start to outpace the cash you have to pay for them. Investing involves a lot of daily ups and downs, but a sound investing plan provides the best opportunity for your money to keep up with inflation.
What should I do when the market drops?
Your best move might be doing nothing. The market drops from time to time; it’s unavoidable. But that doesn’t change your long-term financial goals, and it doesn’t change the plan you have to achieve them. Historically, the market has recovered from every single daily drop and bear market. So if you’re investing for the long term, why sell when prices are temporarily low and be out of the market when the recovery comes?
Whenever you’re feeling concerned, it helps to review your portfolio with a few questions in mind. Are you still on track for your goals? Does your portfolio make sense to you? Are you taking the appropriate amount of risk? If you’re going to make changes to your portfolio, do it because of your goals, not because of what the market is doing.
What’s this going to cost me?
Great question, and one that investors often overlook. Mutual funds have to cover the expense of managing the fund, and some funds charge additional fees. Please read the fund’s prospectus for details on fees, expenses and other important information.
The fees you pay buy investment expertise and services that make investing easier and more suited to your needs. But it’s also true that those fees come directly out of your investment returns. You have to find a balance that you are comfortable with.
Want to learn more? Read about Understanding Mutual Fund Costs.
Will I have to pay taxes?
Taxes make a big difference in how much of your investment returns you keep. You will owe taxes every year on any of your investment gains, including interest, dividends and capital gains. Mutual funds pay dividends based on the income they receive on the securities they hold. If you sell mutual fund shares at a higher price than what you paid for them, that’s a capital gain for you. Separately, mutual funds generate capital gains internally, by selling securities they hold. By law, they must distribute those gains to investors toward the end of the year.
An important concept here is “asset location” — where you keep your investments. There are tax-advantaged accounts like 401(k)s, Roth IRAs and Traditional IRAs. These accounts allow you to put off paying taxes on your investment income far into the future, or in some cases, never. Likewise, Educational Savings Accounts are not taxed, as long as the money is used for qualified educational expenses.
Learn more about how different types of accounts are taxed: It can make a big difference over time.
Homestead Funds does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
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