July is filled with barbecues and picnics, and we celebrate the freedoms we hold dear every 4th of July. That spirit of independence is definitely something worth commemorating, but also something worth emulating. How independent are you, really?
While money is not everything and it certainly can't buy happiness, the having or not having of it can definitely impact your lifestyle. You may have heard the term "independently wealthy", perhaps you've even used it before. Financial independence means having enough wealth not to need employment, nor financial support from any other person. It is what most Americans are aiming for when they begin to plan for their retirement. Let’s explore 3 important principles of wealth accumulation to know in carving out your path to financial independence.
The Many Parts of Risk
Wealth accumulation through investing involves risk, and risk tolerance differs based on your individual risk preference. In the world of finance, risk can take many forms. Here are a few types of risks your financial advisor may discuss with any potential investment:
- Business risk. How healthy is the company behind the investment?
- Market risk. How well will this investment handle the ups and downs of the market and any major economic changes?
- Inflation risk. Will this investment make sense if overall prices go up?
- Liquidity risk. If we need to get rid of an investment in your portfolio, is there a market for it?
- Interest rate risk. This risk entails an investment’s potential to lose value due to a change in interest rates.
While your advisor will consider the investment risk types, you will identify your level of comfortability and establish a risk preference. Typically, lower risk maintains a low growth to your principal, whereas a higher-risk portfolio has a higher growth potential of your money. It is useful to discuss with your advisor which asset classes align with your risk profile and goals of wealth accumulation.
Diversification vs. Asset Allocation: What’s The Difference?
You have probably heard the terms “asset allocation” and “diversification” used in the same sentence, but they are very different concepts that every investor should understand. Asset allocation refers to dividing money among different asset classes, such as stocks, bonds, and cash alternatives. These asset classes have different risk profiles and potential returns.1 The idea behind asset allocation is to offset any losses from one class with gains in another, thereby reducing overall risk in the portfolio.
On the other hand, diversification entails how your money is placed. It is the spreading of your investments around to help reduce the volatility of your portfolio over time. Much like asset allocation, diversification is an investment principle designed to manage risk, but it does not guarantee protection from losses. These two are important to understand when asking your advisor how your money is performing over time.
The Art of Rebalancing
If you notice you are accumulating wealth, most people naturally want to stick to the course to reach potential financial independence. But is this the best approach?
It may sound counterintuitive, but it may be possible to have too much of a good thing. The performance of different investments can shift a portfolio’s intent and risk profile, which usually occurs over a period of time. Rebalancing is the process of restoring a portfolio to its original risk profile. Rebalancing can happen in two ways:
#1: Use new money. When adding money to a portfolio, allocate these new funds to assets or asset classes that have fallen. But remember that diversification is an investment principle designed to manage risk, but it does not guarantee protection from losses.
#2: Sell enough of the “winners” to buy more underperforming assets. Ironically, this type of rebalancing actually forces you to buy low and sell high.
Periodically rebalancing your portfolio to match your desired risk tolerance is a sound practice regardless of market conditions. It can ensure you are keeping your goals of financial independence at the forefront of the planning process.2,3.
Identifying the core tenets of wealth accumulation is important in understanding how to reach financial independence. Remember to consult your wealth advisor regularly, discuss the right risk strategy for you, and adhere to your goals through step-by-step action planning.
- Investor.gov, 2021
- DQYDJ.com, 2020
- TreasuryDirect.gov, 2020
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
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