Sound investing means using the right tools and diversifying

B oy, I wish I knew at 21 what I know today.

I certainly made a whopper of an investment error in my early days of adulthood. When I first began investing for my retirement, I followed the advice of a co-worker and put all my 401(k) retirement money in bonds.

“You can’t trust the stock market,” he told me.

Well, during the time I was in bonds, the stock market soared. The returns on my mutual bond funds were pitiful.

I made a classic novice mistake – getting my investment advice from an unqualified source. It didn’t occur to me that my co-worker was basing his advice on his own situation. He was close to retiring and had an ultraconservative money style.

I eventually realized my mistake and rebalanced my 401(k) portfolio.

Still, I could kick myself for the money I missed out on. But you live and learn, right?

Actually, the answer is yes and no.

Certainly experience can teach us a lot, but ask the right questions and go to the right source when you’re young and you can learn early.

I’m thrilled when I get questions from college students and recent graduates during my regular online discussions at www.washingtonpost.com.

For example, here’s a good one from a graduate: “I am trying to purchase a home in the next two years, what would be a good place to start investing the money I have started saving?”

First, let me define investing. It means to commit money with the expectation of a financial gain. It also means you are putting your money at risk.

If you are saving up for a home or you need it for any other reason in the next five years, you do not want to invest this money.

As an investor, you want to give your money both time to grow and also time to weather the ups and downs that can happen with stocks and bonds, whether they are purchased individually or within a mutual fund.

So for these purposes, consider stashing your cash in a money market deposit account, a money market mutual fund or several CDs that mature over the next few years.

There is a difference between a money market deposit account and a money market mutual fund. A money market deposit account is an interest-earning savings account offered by an FDIC-insured financial institution with limited transaction privileges. The interest rate paid on such an account is usually higher (but not always) than a regular savings account.

A money market mutual fund is not federally insured. When you invest in these types of funds, your principal is not guaranteed. But the risk of losing money is extremely low. Money market mutual funds usually invest in Treasury bills, bank CDs and high-rated corporate bonds. Usually this account will pay higher than a money market deposit account. Shop around for the best rates (www.bankrate.com is a good source) and be mindful of fees you may be charged.

I loved this question from a 22-year-old student who is already investing:

“I’ve read that a lot of financial experts suggest investing in the S&P 500,” the student wrote. “Since I have a long time until retirement, wouldn’t it make more sense to invest in a small-cap fund since they tend to get a few percent more per year? Why wouldn’t more long-term investors want to put all their money into something with the potential for a larger return?”

The S&P 500, or Standard &Poor’s 500, is an index made up of 500 large publicly held companies. A small-cap mutual fund is made up of shares in small companies. Yes, a small-cap fund has the potential to return big gains because you’re investing in companies with the potential for great growth. But just like any sector, it can and does tank.

When it comes to investing there is a key word that all investors – not just young ones – need to sear into their minds: “diversification.”

Here’s a good definition from Investopedia.com (another good source of investing information): “Diversification is a technique that reduces risk by allocating investments among various financial instruments (stocks, bonds), industries and other categories. It aims to maximize return by investing into different areas that would each react differently to the same event.”

You should diversify because to do otherwise isn’t investing, it’s gambling.

Unfortunately, the following is a question that I get far too often.

The numbers change but the bottom-line situation is the same: “I am 23 and I have $2,000 in credit card debt and $100 in savings. I want to get rid of that $2,000 debt, and start saving. What is reasonable for a girl like me to have saved?”

You should have at a minimum three months of living expenses saved up – even if you’re in college. That means having enough emergency money to cover your bills and expenses for three months.

It’s wise to save even if you have debt, that way you can avoid adding to your debt when a financial emergency happens – and it will.

You know what? When it comes to your money, don’t wait for experience to be your best teacher. You can lose a lot of money that way.

Washington Post Writers Group