A good investment plan is to begin slowly, choosing low-risk, predictable and stable options. Then, as your comfort level increases and your have more money to risk, expand into choices with greater potential profits (but losses).

What is investment planning?

A good financial plan begins first with setting aside a portion of your current income to provide for future needs. When you first begin to earn a paycheck, your savings will be temporary. You will put your paycheck into an account and take money out as needed to pay bills. This money is your emergency fund. The purpose of this money is to pay for your short-term needs with enough left over to cover unexpected expenses, such as car repairs or medical bills not covered by insurance. Once your short-term saving needs are covered, you can begin investing.

Once your short-term saving needs are covered, you can begin investing.

Unless you want to start your own business, investing is how you turn money into more money. It grows through the power of compounding. Why should you invest? Your money will grow faster and require the least amount of work. Plan for what you want to use the money for and chose an investment style to match the goal. For example, if you one of your goals is to buy a house, then match this goal to the investment type that makes sense based on when you need the money (is it a short-term or long-term goal?).

Your goals for saving and investing will be different, depending on your lifestyle, age, purpose for saving or investing and income. But it’s important to understand that with investing it’s more than just looking for higher long-term returns. You need to know that to the extent you invest in stocks, you are going to have big ups and downs that might not be expected. Big dips are just part of the game, and you’ll lose if you panic and take your money out every time they happen.

Why should I have an investment plan?

There are many reasons you should consider investment planning as part of your long-term financial plan. If done correctly, it is the only money-saving strategy that actually helps your money grow.

• Investing is a long-term endeavor — do it right and you shouldn't lose any sleep because time is on your side.
• Your money will grow over time, rather than lose value due to inflation.
• You'll build wealth over time, which will enable you to retire some day.

Investing helps beat inflation. Inflation is a rise in the general level of prices over time. As prices rise, it takes more money to buy goods and services. So you can invest for the long term and your investments should grow faster than the inflation rate.

It may seem like saving money is a good-enough strategy to help you build wealth over your lifetime. But most savings accounts don't offer enough interest to cover inflation. So while you may be making money in interest (always a good thing), the world around you is getting more expensive and your $1,000 today will be worth less in the future.

Once I have a plan, how do I invest?

When you invest, you careful manage the securities — stocks, bonds, mutual funds, for example — that you buy in order to to maximize growth of your portfolio (collection of investments) over the long run. The "long run" means 10 years or more. You invest in different types of securities to try to maximize your returns, while also limiting your risk of losses. Your investment mix is called your asset allocation. Coming up with your asset allocation is the first step in building your portfolio.

• See also: Stocks, Bonds, Mutual Funds

 The question you need to ask yourself is how long will it be until you need the money? The longer you have to invest, the less risk you’ll have using asset classes that go up and down a lot in value. If you are saving for a down payment for a home, then short-term bonds can be a good option because they’re low risk and should give better returns than a regular savings account. For longer-term goals, you can be more aggressive and invest in stocks, because their frequent ups and downs that happen month to month are less likely to affect you.

Investment planning is too big a topic to summarize in a short help guide, but here’s an introduction to a few key concepts:

• Asset allocation
• Risk and return
• Diversification
• Rebalancing

What is asset allocation?

Asset allocation is the division of your money into stocks, bonds and cash, and the further division into sub-categories such as foreign stocks or short-term bonds. These main categories of investments are called asset classes. Choosing your asset allocation is actually the most important decision you’ll make in investing. For example, choosing between investing 100% of your money in bonds or splitting it 50/50 between stocks and bonds will have a bigger impact than what specific types of stocks and bond mutual funds you invest in.

Below are some examples of simple asset allocations.

100% short-term, investment-grade bonds

These investments are very stable and their value won’t drop much. Use this type of investment for extra cash for an emergency fund, saving up for a down payment on a home or any other money you might need in the next couple of years.

• See also: Emergency funds

60% stocks and 40% bonds

This is a common mix for pension funds and similar long-term investors. This mix is also a good starting point for creating a good mix of investments for retirement accounts.

• See also: Retirement

40% U.S. stocks, 20% foreign stocks and 40% short- and intermediate-term bonds

This is a more specific version than the 60% stocks and 40% bonds mix, but it’s also where you get into more subjective decisions that are based on your risk tolerance and long-term goals.

100% stocks

This mix is very risky with frequent swings up and down and isn’t ideal for most people. When you put all your investments in stocks, you leave yourself exposed to market ups-and-downs.

80% stocks and 20% bonds

This mix is similar to owning 100% stocks, but the bonds help to offset the stocks so you'll see smaller dips along the way.

What is risk and return?

The purpose of investing is to earn higher returns than you earn on savings like in a regular checking account at your bank or credit union. In order to do this, you must take on more risk. When choosing investments, it’s important to decide how much risk you are comfortable with taking.

But also, you might decide the risk of losing money isn’t worth it (your investing goal isn’t always “maximum upside”). So the investment type you pick isn’t based as much on time frame as it is on the risk of loss. For example, if you have $10,000 and need it in five years — and not a dime less — that’s enough time to invest in something a little riskier than a savings account. However, if you don’t like to risk losing any of that money, you might just buy a five-year government bond because safety is most important to you.

Reducing risk for most people means reducing the risk that you’ll lose money. Investing in the stock market is risky because stocks are volatile, meaning they can go up and down a lot in value, which really stresses out some people. Remember those ups and downs are just part of investing — but you should only focus on the down part.

But also important is the risk of losing money relative to inflation. If you stick your cash under your mattress you might not lose it, but in 20 years it will buy a lot less than it will today. That’s why a savings account is risky for retirement savings — your money might not be keeping up with inflation. Volatility is the enemy of a short-term investor; inflation is the enemy of the long-term investor.

What is diversification?

Diversification means, simply, not putting all your eggs in one basket — owning a mix of investments instead of just one or a few of them. It can be described in two contexts: diversifying across asset classes and diversifying within the asset class.

Diversifying by owning a mix of different asset classes should reduce your risk, because not all of your investments will move up and down together. For example, owning only U.S. stocks is riskier than also owning bonds, foreign stocks and REITs because it’s likely that at least one of these asset classes will behave differently when others are going down. That provides more stability within your portfolio.

Within each asset class, owning more investments reduces your risk of loss as well. Owning one stock is extremely risky; if that company goes bankrupt, you lose all your money. Owning 500 stocks is much less risky, because no single company’s bankruptcy will have much of an effect on the value of your portfolio.

What is rebalancing?

It’s very important as part of your investment plan to check in on your portfolio periodically. If you are saving for the long term, such as for retirement, you might only do this once per year. And even then, you might not need to do anything to you portfolio.

Rebalancing is the process of getting your investment mix back to what you planned it to be. You might have to sell some investments that have gone up or buy more of something that’s gone down. This is often done in the context of a mutual fund portfolio.

Why make rebalancing an important part of your investment plan?

When you rebalance, you make sure that your investments are meeting your goals. Rebalancing is best planned in advance — so you know what you want to achieve with your investments and how you should adjust your portfolio to meet your goals. In general, want to sell investments when they’re doing well and buy investments that have gone down. History shows those are exactly the times when you should make these moves — but few people without a plan actually buy stocks after those market dips, because those times are always accompanied by a lot of bad news.

In general when you rebalance you want to:

• Buy low, sell high
  You can sell any investments that have gone up significantly and buy those that have gone down.

• Reduce risk
  Rebalancing allows you to look at any gains and losses make sure you don't have a mix of investments that are too risky or too safe. For example, when your stocks go up a lot, they become a bigger part of your portfolio, which means you have more risk of loss.

How do I create an investment plan?

Here are six steps to take when creating an investment plan:

1. Define your financial goals.

What are you investing for? If there are any specific amounts or, especially, dates when you know you’ll need to tap into your investments, write them down because they’ll drive your whole plan. It’s common not to have specific goals for all of your savings, but at least pin down the dates and amounts of expected withdrawals.

2. Understand the different asset classes and their risks.

A good source of information on this is the websites of index mutual fund companies such as the Vanguard Group or the iShares site.

3. Decide what asset allocation is right for your goals.

You’ll have different allocations for different goals – your retirement savings shouldn’t be invested the same way as your new-car fund.

4. Choose your investments.

We recommend focusing on low-cost index funds given that your asset allocation is by far your most important decision.

5. Come up with a rebalancing plan.

Will you check in every month, every year, or just when you have new money to invest?

6. Put it in motion.

And check in accordingly to your plan.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Moody’s Investors Service: www.moodys.com
• Standard and Poor's (S&P): www. standardandpoors.com
• Kiplinger’s Personal Finance: www.www.kiplinger.com