Do you feel confused or intimidated by investing? Does it seem like a foreign language that you’ll never be able to master? Or something that only wealthy people can do? Trust me, I get it.
Luckily, there are really only four - yes, FOUR! - fundamental investing terms that you need to understand in order to start building wealth for the future.
# 1 - Asset class
The first investing term that you need to know and understand is asset class. This term answers the “What can I invest in?” question.
An asset class is a category of investments. There are four main asset classes:
Each of them has their own investment characteristics and risk/reward profiles. You should invest in each of them in specific amounts (or not at all!) to achieve your financial goals.
# 2 - Allocation
Your investment allocation is the general mix of asset classes that you’re invested in. If anyone ever asks you “How are you invested?” , this is what they’re getting at.
You could be 100% invested in stocks. Or maybe 50% in stocks and 50% in bonds…
Whatever it is, your allocation is what will determine your investment success or failure (see why in #4 below). It’s critical for you to understand what your allocation is and how you can change it to reach your goals.
# 3 - Diversification
You’ve probably heard that you shouldn’t put all of your “investing eggs” in one basket, right? Diversifying your money across asset classes and within asset classes helps reduce your overall investing risk by spreading the risk around.
However, you can over do it. A common mistake people make when trying to diversify is putting equal percentages of their portfolio in each fund available. That’s called naive diversification and can also be damaging to your investing success.
Diversifying should be done strategically in order to earn the highest possible return for the lowest amount of risk.
# 4 - Weighted Average Portfolio Return
This is the combined return that your portfolio earns and is expected to earn based on:
which asset classes you’re invested in,
the percentage of each in your portfolio allocation, and
how diversified you are.
For example, if your allocation is 100% stocks, and stocks have historically earned ~10% per year, you would expect your portfolio to earn 100% x 10%. = 10% per year.
If, however, half of your portfolio is invested in stocks and half is in cash, your expected return will look a lot different because cash doesn’t earn as high of a return as stocks. That’s why your allocation is SO important and something you need to choose and monitor wisely.
Learn More About Investing
If you want to learn a lot more about investing and how to build a portfolio to achieve long-term goals like saving for retirement, enroll in my WEALTH course. I dive even deeper into all of these concepts there, and offer custom calculators to help you plan for your big financial dreams.
If you need help with other personal finance topics like your money mindset, budgeting, credit, and insurance too, then enroll in my MONEY course, which includes everything in the WEALTH course and more.