Financial Planning Guide: Key Investment Concepts

Compounding. One of the easiest ways to make your nest egg grow is to reinvest dividends and interest. By simply rolling over these funds, you can make it possible for your investment to flourish. If you had invested $100 in a typical stock at the end of 1926 and spent all of the dividend payments, you would have ended up with less than $3,000 by 1990. If you had reinvested the dividends, you would have had more than $55,000 to your credit!

Asset allocation. This sounds complicated, but all it means is how you divide your investment funds between the three major categories: stocks, bonds, and cash or cash equivalents. (Checking accounts and money-market funds are considered cash equivalents because they are so liquid.) Younger investors will tend to have more money in aggressive stocks with strong growth potential.

Older investors, seeking to generate steady income and preserve their capital, will tend to have more in cash and bonds. One good rule of thumb: take your age and put a percentage sign behind it. Never let your cash holdings (the most conservative and, as a result, lowest-returning investments) exceed the resulting percentage.

Diversification. As is true in most things in life, it doesn't pay to put all of your eggs in one basket when investing. You can cut your risk of suffering major losses by spreading out your investments across stocks, bonds, and cash, as well as across more than one mutual fund. You should also seek diversification among the types of stocks and mutual funds in which you invest.

Rather than putting all of your assets in high-tech mutual funds, you may also wish to have substantial portions of your nest egg in international funds and tax- free municipal bond funds. The idea is to decrease your exposure to risk and to increase your potential for profit by having at least some of your money in the right place at the right time.