BI > JANUARY 2004

Building a Sound Foundation

Top 10 Financial Concepts

The new year is time to reflect on those areas of our lives that need improvement. Many first-time investors jump into the fray without a solid knowledge of the basics of personal finance and investing. They get caught up in the "noise" of day-to-day, short-term objectives discussed on financial news channels.

It's easy to lose track of the basic concepts that disciplined investors practice. A sound foundation requires solid building blocks. What are the key building blocks all financially literate people should have when constructing a sound foundation of personal finance and investing knowledge? Here are my top concepts:

1. Investing as a Priority

While learning about investing is extremely important, I believe you need to have other aspects of your financial life in order first. Certainly adequate control of your debt situation is imperative. Too many people fall victim to over-extending on their credit cards and their interest rates of 18-21 percent.

Young adults are particularly vulnerable to this problem. It looks like easy money when you whip out the plastic to pay for an item. The difficulty comes when you don't have sufficient income to pay off the debt. When you just pay the minimum amount due you'll get caught up in the everlasting credit card cycle.

In addition, I think you need to determine the proper levels of insurance (property, life, health, etc.) for your situation before you spend your hard-earned dollars on investments. I would start the investing process after the fundamental insurance and credit situations are satisfied.

2. The Concept of Time and Money

Many young people have no understanding of the power of time in the investing process. When they understand how money compounds and "snowballs" over long periods, they have mastered one of the most significant financial concepts. Youths need to learn this important concept right away, not when they're in their 50s. Reinvesting interest, dividends and capital gains fuels the compounding process and is critical to your financial foundation.

3. Financial Goals Are Key

You should have reasons why you're saving or investing. Are these goals short term or long term? Are you investing for the down payment on your first home or for your retirement? How much will you need? You should put those goals in writing. I believe it's important to review them periodically. The process of setting goals is critical to your financial well-being.

4. An Evolving Plan

After you determine your goals, you need to develop a plan for reaching them. This is where the concept of time and money comes into play. If you have started the investment process at an early age, you should have more time to fund your plan by making periodic payments to the appropriate investment vehicles.

5. Realistic Expectations About Types of Investments

It's critical that first-time investors have reasonable expectations of risks and returns for the various types of investments available. Over the past eight decades fixed-income investments (such as money market funds, corporate bonds, and Treasury notes and bonds) produced total returns significantly below those of common stocks. The common stock portion of a portfolio had an average total return of 10-12 percent.

Expectations that you're going to get 50 percent, 100 percent or 200 percent on your money in a short time are unreasonable. Getting rich quickly is a concept many people buy into because they have unreasonable expectations about wealth accumulation. Unfortunately, many folks who haven't grasped this concept still fall victim to high-risk situations.

But NAIC principles focus on the "get rich slowly" school of thought. It's a much more reasonable and attainable goal.

6. Know Thyself

You need to know your own comfort level for risk, which is usually defined as the volatility associated with your investments. Staying within your comfort zone is smart. Don't be pressured into investing in vehicles that you don't understand.

You also need to establish how active you plan to be with your investments and how much time you'll commit to the process. Will you be active or passive? Do you have the time to research and stay on top of your individual common stock portfolio, or will you prefer to use mutual funds as your investment strategy?

7. Asset Allocation

Another critical building block of financial literacy is diversification. To me this means having a portfolio that has different asset classes (such as stocks, bonds and cash), with each class diversified by industry type, company size and other criteria.

Many lessons were learned the hard way from having too much of one company's common stock in 401(k) plans. Having 60 percent of your portfolio in one stock can be a disaster, as the Enron employees who lost a ton in their 401(k)s can tell you.

It's critical that beginning investors learn the fundamental concept of having a diversified portfolio.

8. Periodic Investing

The 52-year-old NAIC belief in periodic investing is still in vogue. Putting monthly or quarterly sums into your investments is a must in the learning process.

Too many folks sit on the sidelines, too nervous and unsure about whether it's a good time to invest. History has proven that periodic investing is a building block of wealth accumulation.

9. The Importance of Growth Equities

The common stocks of solid, quality companies that are growing faster than the general national economy are vehicles to wealth accumulation. This concept, another NAIC principle, is an integral part of a sound foundation of knowledge.

10. The Relationship of Common Stock Prices to Key Variables

Many new investors have difficulties with the concept of price-earnings ratios and how they relate to the valuation process. NAIC stock study tools offer guidance on this critical piece of the puzzle. Once mastered, this concept can help investors avoid stocks with P/Es of 250 as seen in the late 1990s.

The greatest gift we can give to our children is the knowledge we have gained from our lifelong experiences. If you have mastered these 10 major personal finance concepts, you're well on the road to a successful and prosperous new year.

Jeff is director of educational development for BetterInvesting. Readers interested in sharing their experiences and stories about young investors are invited to contact Jeffery Fox at BetterInvesting or at jefff@better-investing.org