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How to come up with a profitable business idea?

How to recognize a profitable business idea?

1. Start with family. Tapping family for great business ideas may not seem like an obvious first step. Sure, you'll hit them up for cash once you've developed your idea, but what can your aging father or cousin Margaret contribute this early in the process? Plenty. Donald Trump certainly wasn't bashful about learning the real estate business from his dad, Fred, who ran a thriving real estate development company, says Ries. Trump had the good sense to get some priceless training before going off to become one of the country's foremost builders and real estate developers. "If his father hadn't provided the foundation and training [he needed] to create a profitable business, Trump wouldn't be where he is today," Ries explains. "Unfortunately, many people insist on [creating a business] themselves without any help from their family. That's foolish."

2. Get a little help from your friends. Ries says you are severely limiting yourself if you rely solely on your own ideas--especially when your creative juices run dry. "This is reason enough to listen to ideas others may have," he says. "If you have 15 or 20 friends, chances are a couple of them have some incredible business ideas."

3. Look at all the things that bug you. It may not sound profound, but Ries says this is fertile ground for great business ideas. He cites how upset Kemmons Wilson was in the 1950s when a motel owner wanted to charge him an additional price for each of his five children. He was so ticked off, he launched Memphis, Tennessee-based Holiday Inn, today one of the world's largest hotel chains.

If King C. Gillette hadn't been fed up with the tedious process of sharpening his straight-edge razor, he wouldn't have founded the massive disposable razor industry. When he took his idea for a portable razor with a blade that could be used several times to a research university for assistance, engineers questioned his sanity. Gillette followed his instincts and the rest is history.

4. Tap your interests. Thousands of clever people have taken up hobbies and turned them into a successful business. Tim and Nina Zagat, who launched the Zagat Surveys, a publishing empire that sells restaurant guides for many major U.S. and European cities, are great examples. In the early 1970s, the Zagats were high-priced corporate attorneys whose passion was dining out. For fun, they created a newsletter in which they asked their friends to rank popular restaurants in several categories. Each year, the newsletter encompassed more restaurants. Eventually it became such an expensive and time-consuming undertaking that the couple began charging money for it to allay their expenses. That was the meager beginning of the famed Zagat Survey, which is sold in bookstores worldwide. "When you're doing something you love, it's never considered work," says Ries.

5. Travel. Traveling opens your eyes to a plethora of potential business ideas. Ries cites Leopoldo Fernandez Pujals' discovery of Domino's Pizza on a trip to the United States from his native Spain. Pujals was so impressed with the fast-food operation, he went back to Spain and launched his own version, called TelePizza, in 1986. His company now registers $260 million in sales, and employs 13,000 people in eight countries.

6. Keep your eyes open. "When you see something that piques your interest, ask yourself, What is it about this situation that's special?" says Ries. "Then narrow your focus so you home in on the idea." The process of zeroing in on the idea often spawns important niche markets. "Blockbuster Video's niche is renting videos, and Bulbs Unlimited's niche is selling light bulbs," says Ries. Get it?

7. Examine old mousetraps--then build a better one. "If a product doesn't meet your own high standards, create a better one," advises business trendwatcher Perry Lowe. "That's what put Ben & Jerry's on the map." Ice cream fanatics Ben Cohen and Jerry Greenfield felt popular ice creams weren't rich and tasty enough for their cultivated palates, so they created their own super-premium line of ice cream, which is a bestseller nationwide. Just think: If these ice cream gurus weren't such picky eaters, there would be no Cherry Garcia, Chubby Hubby or Phish Food to enjoy.

8. Take it to the streets. There's no better place to lock into up-and-coming trends than city streets, Lowe contends. Street culture spawned punk, hip-hop, grunge and a number of other fads that rapidly evolved into multimillion-dollar businesses. "Great ideas can often be found by just browsing happening inner-city neighborhoods in virtually any big city in the United States," says Lowe.

9. Sleep on it. Many people ignore their dreams, and some don't remember them at all. But sometimes it pays to listen to those inner messages, no matter how strange or unintelligible they are. "You never know, you might just find the germ of a great idea," says Lowe. The tough part is crawling out of bed in the dead of night to jot down those great ideas before they're forgotten.

10. Check out the Net. Finally, Lowe endorses Web surfing as a fun way to log on to potential business ideas. "Virtually every search engine has a 'What's New' or 'What's Hot' section, where it lists new trends, news tidbits and hot new Web sites," says Lowe. "Make it a point to check out various sites daily. It may trigger an idea or concept you never thought of."

What types of investments exist?

1. Ownership Investments

Ownership investments are what comes to mind for most people when the word "investment" is batted around. They are the most volatile and profitable class of investment. The following are examples of ownership investments:

Stocks: A stock is literally a certificate that says you own a portion of a company. More broadly speaking, all traded securities, from futures to currency swaps, are ownership investments, even though all you may own is a contract. When you buy one of these investments, you have a right to a portion of a company's value or a right to carry out a certain action (as in a futures contract).

Your expectation of profit is realized (or not) by how the market values the asset you own the rights to. If you own shares in Apple (AAPL

) and the company posts a record profit, other investors are going to want Apple shares too. Their demand for shares drives up the price, increasing your profit if you choose to sell the shares.

Business: The money put into starting and running a business is an investment. Entrepreneurship is one of the hardest investments to make because it requires more than just money. Consequently, it is also an ownership investment with extremely large potential returns. By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world's richest men, is a prime example.

Real Estate: Houses, apartments or other dwellings that you buy to rent out or repair and resell are investments. However, the house you live in is a different matter because it is filling a basic need. It fills a need for shelter and, although it may appreciate over time, shouldn't be purchased with an expectation of profit. The mortgage meltdown of 2008 and the underwater mortgages it produced are a good illustration of the dangers in considering your primary residence an investment.

Precious objects and collectibles: Gold, Da Vinci paintings and a signed LeBron James jersey can all be considered an ownership investment - provided that these are objects that are bought with the intention of reselling them for a profit. Precious metals and collectibles are not necessarily a good investment for a number of reasons, but they can be classified as an investment nonetheless. Like a house, they have a risk of physical depreciation (damage) and require upkeep and storage costs that cut into eventual profits.

2. Lending Investments

Lending investments allow you to be the bank. They tend to be lower risk than ownership investments and return less as a result. A bond issued by a company will pay a set amount over a certain period, while during the same period the stock of a company can double or triple in value, paying far more than a bond - or it can lose heavily and go bankrupt, in which case bondholders usually still get their money and the stockholder often gets nothing.

Your savings account: Even if you have nothing but a regular savings account, you can call yourself an investor. You are essentially lending money to the bank, which it will dole out in the form of loans. The return is currently quite low, but the risk is also next to nil because of the Federal Deposit Insurance Corporation (FDIC).

Bonds: Bond is a catch-all category for a wide variety of investments from Treasuries and international debt issues to corporate junk bonds and credit default swaps (CDS). The risks and returns vary widely between the different types of bonds, but overall, lending investments pose a lower risk and provide a lower return than ownership investments.

3. Cash Equivalents

These are investments that are "as good as cash," which means they're easy to convert back into cash.

Money market funds: With money market funds, the return is very small, 1% to 2%, and the risks are also small. Although money market funds have "broken the buck" in recent memory, it is rare enough to be considered a black swan event. Money market funds are also more liquid than other investments, meaning you can write checks out of money market accounts just as you would with a checking account. (For more on black swan events, see Black Swan Events and Investing.)

What About Investing in Your Education?

Education: Your education is often called an investment and many times, it does help you earn a higher income. A case could be made for you "selling" your education like a small business service in return for income like an ownership investment.

The reason it's not technically an investment is a practical one. For the sake of clarity, we need to avoid the absurdity of having everything be classified as an investment. We'd be "investing" every time we bought an item that could potentially make us more productive, such as investing in a stress ball to squeeze or a cup of coffee to wake you up. It is the attempt to stretch the meaning of investment to purchases, rather than education, which has obscured the meaning.

These Items Are Not Investments

Consumer purchases: Beds, cars, mobile phones, TVs and anything that naturally depreciates with use and time - are not investments. As an example, you don't invest in a good night's sleep by buying a foam pillow. Unless you're very famous, and even then, it's a stretch, since you can't reasonably expect someone to pay more for your pillow than the initial purchase cost. Don't take it personally, but there's very little demand in the second-hand pillow market.

The Bottom Line

There are three types of investments: ownership, lending and cash equivalents.

There is no fourth category of consumer purchases. Admittedly, it's a clever piece of advertising that removes some of the guilt from impulse purchasing; you're not spending money frivolously, you're investing! The decisive test is whether there is a potential to turn a profit. The important word is "potential" because not every legitimate investment makes money.

Making money through investing requires researching and evaluating different investments, not simply knowing what is and is not an investment. That said, being able to see the difference between an investment and a purchase is an essential first step.

What knowledge do you need to make an smart investment?

HOW SECURITIES ARE BOUGHT AND SOLD

The term "securities" encompasses a broad range of investments, including stocks, corporate bonds, government bonds, mutual funds, options, and municipal bonds. Investment contracts, through which investors pool money into a common enterprise managed for profit by a third party, are also securities. Securities may be traded on an organized exchange or traded "over the counter" between investors.

Exchanges

Securities are bought and sold in a number of different markets. The best known are the New York Stock Exchange and the American Stock Exchange, both located in New York City. In addition, six regional exchanges are located in cities throughout the country.

A corporation’s securities may be traded on an exchange only after the issuing company has applied to the exchange and met any listing standards relating, for example, to the company's assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions. The exchanges facilitate a liquid market for securities where buyers and sellers are brought together. Listing on an exchange, however, does not constitute approval of the securities or provide any assurance as to risk and return.

Over-The-Counter

Many securities are not traded on an exchange but are traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers' Automated Quotation System (NASDAQ), which is run by the National Association of Securities Dealers (NASD), trading in OTC stocks is done via on-line computer listings of bid, which asks prices and completes transactions.

Like the exchanges, NASDAQ has listing standards that must be met for securities to be traded in that market. Similar to an exchange it provides a "meeting place" for buyers and sellers. The typical investor generally will not know whether their security is bought or sold through and exchange or over the counter. The investor engages a broker who arranges the transaction in the appropriate market at the desired price.

Brokers

If you buy or sell securities on an exchange or over the counter, you will probably use a broker, and your direct contact will be with a registered representative. The registered representative, often called an account executive or financial consultant, must be registered with the National Association of Security Dealers (NASD), a self-regulatory organization whose operations are overseen by the Securities and Exchange Commission (SEC), and with the states in which the broker is conducting business. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.

HOW PRICES ARE ESTABLISHED

How are the stock prices that appear in the financial section of the newspaper arrived at? Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways.

Exchange Prices

The exchanges centralize trading in each security at one location—the floor of the exchange. There, auction principles of trading set the market price of a security according to current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.

Over the Counter

In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiate the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.

In some cases, a customer's brokerage firm may itself act as a dealer, either selling a security to a customer from its own inventory or buying it from the customer. In such cases, the broker hopes to make a profit on the purchase and sale of the security, but no commission is charged. Instead, a retail "mark up" is added to the price charged by the firm when a customer buys securities and a "mark down" is deducted from the price paid by the firm when a customer sells securities.

Bid and Ask Prices

In both cases, a stock is quoted in terms of bid and ask. The bid is the price at which the market or market maker is willing to buy the security from you. Similarly the ask is the price at which the market or market maker is willing to sell the security to you. Not surprising, the ask price is higher than the bid price. The difference between the two is called the spread. For example, if a stock is quoted 18-18 ¼ , this means that the investor could sell the stock for $18 a share or purchase the stock for $18.25. The higher the spread the more the market maker profits and the higher the cost to investors. Heavily traded securities typically have narrow spreads while infrequently traded securities can have wide spreads.

HOW YOUR SECURITIES ARE PROTECTED

Investors’ money is protected in three ways: by federal laws and regulations, enforced by the SEC; by self-policing in the industry; and by state law.

Under the federal securities laws, those engaged in the business of buying and selling securities have a great deal of responsibility for regulating their own behavior through SROs (self-regulatory organizations) operating under the oversight of the SEC. These SROs include all of the exchanges; the NASD; the Municipal Securities Rulemaking Board (MSRB), which establishes rules that govern the buying and selling of securities offered by state and local governments; and other organizations concerned with somewhat less visible activities such as the processing of transactions.

The SROs are responsible for establishing rules governing trading and other activities, setting qualifications for securities industry professionals, regulating the conduct of their members, and disciplining those who fail to abide by their rules.

In addition, the federal securities laws provide investors with certain protections, including the ability to sue if they have been harmed as a result of certain violations of those laws.

Many brokerage firms may require that their customers sign an agreement containing an arbitration clause when they open a brokerage account. If you sign an agreement with an arbitration clause, you are agreeing to settle any future disputes with the broker through binding arbitration, instead of through the courts.

Arbitration proceedings are administered by the SROs, and the rules that apply in arbitration proceedings are specified by each SRO. Although the SEC oversees the arbitration process, it cannot intervene on behalf of or directly represent individual investors, nor can the SEC modify or vacate an arbitration decision. The grounds for judicial review are very limited.

Further protection for investors is provided by state laws designed to regulate the sale of securities within state boundaries.

The Function Of The SEC

The SEC, an independent agency of the U.S. Government, was established by Congress in 1934 to administer the federal securities laws. It is headed by five Commissioners, appointed by the President, who direct a staff of lawyers, accountants, financial analysts, and other professionals. The staff operates from its headquarters in Washington, D.C. and from five regional offices and six district offices in major financial centers throughout the country.

The SEC's principal objectives are to ensure that the securities markets operate in a fair and orderly manner, that securities industry professionals deal fairly with their customers, and that corporations make public all material information about themselves so that investors can make informed investment decisions. The SEC accomplishes these goals by:

Mandating that companies disclose material business and financial information;

Overseeing the operations of the SROs;

Adopting rules with which those involved in the purchase and sale of securities must comply; and

Filing lawsuits or taking other enforcement action in cases where the law has been violated.

Despite the many protections provided by federal and state securities laws and SRO rules, it is important for investors to remember that they have the ultimate responsibility for their own protection. In particular, the SEC cannot guarantee the worth of any security. Investors must make their own judgments about the merits of an investment.

What Companies Must Disclose

Before any company offers its securities for sale to the general public (with certain exceptions), it must file with the SEC a registration statement and provide a "prospectus" to investors. In its registration statement, the company must provide all material information on the nature of its business, the company's management, the type of security being offered and its relation to other securities the company may have on the market, and the company's financial statements as audited by independent public accountants. A copy of a prospectus containing information about the company and the securities offered must be provided to investors upon or before their purchase. In addition, most companies must continue to update, in filings made with the SEC, this disclosure information quarterly and annually to ensure an informed trading market.

The SEC reviews registration statements and periodic reports for completeness, but the SEC does not review every detail and verification of each statement of fact would be impossible. However, the securities laws do authorize the SEC to seek injunctive and other relief for registration statements containing materially false and misleading statements.

Persons who willfully violate the securities laws may also be subject to criminal action brought by the Department of Justice leading to imprisonment or criminal fines. The laws also provide that investors may be able to sue to recover losses in the purchase of a registered security if materially false or misleading statements were made in the prospectus or through oral solicitation. Investors must seek such recovery through the appropriate courts, since the SEC has no power to collect or award damages or to represent individuals.

How the SEC Supervises Industry Professionals

Another important part of the SEC's role is supervision of the securities markets and the conduct of securities professionals. The SEC serves as a watchdog to protect against fraud in the sale of securities, illegal sale practices, market manipulation, and other violations of investors' trust by broker-dealers, investment advisers, and other securities professionals.

In general, individuals who buy and sell securities professionally must register with the appropriate SRO, meet certain qualification requirements, and comply with rules of conduct adopted by that SRO. The broker-dealer firms for which they work must, in turn, register with the SEC and comply with the agency's rules relating to such matters as financial condition and supervision of individual account executives. In addition, broker-dealer firms must also comply with the rules of any exchange of which they are a member and, usually, with the rules of the NASD.

The SEC can deny registration to securities firms and, in some cases, may impose sanctions against a firm and/or individuals in a firm for violation of federal securities laws (such as, manipulation of the market price of a stock, misappropriation of customer funds or securities, or other violations). The SEC polices the securities industry by conducting inspections and working in conjunction with the securities exchanges, the NASD, and state securities commissions.

PROTECTING YOURSELF

You should be as careful about buying securities as you would be about any other costly purchase. The vast majority of securities professionals are honest, but be aware that misrepresentation and fraud do take place. Observe the following basic safeguards when "shopping" for investments:

Never buy securities offered in unsolicited telephone calls or through "cold calls" — ask for information in writing before you decide. Check on the credentials of anyone who tries to sell you securities.

TIP:

Beware of salespeople who try to pressure you into acting immediately.

Don’t buy on tips or rumors. Not only is it safer to get the facts first, but also it is illegal to buy or sell securities based on "inside information" which is not generally available to other investors.

Get advice if you don't understand something in a prospectus or a piece of sales literature.

TIP:

Be sure you understand the risks involved in trading securities, especially options and those purchased on margin. Be skeptical of guarantees or promises of quick profits. There is no such thing--without an accompanying increase in risk.

: Please refer to

Six Investing Pitfalls To Avoid

Remember that prior success is no guarantee of future success in an investment arrangement.

With tax-sheltered investments, partnerships, and other "liquid" investments, be sure to ask about the liquidity and understand that there may not be a ready market when you want to sell.

Don't speculate. Speculation can be a useful investment tool for those who can understand and manage the risks involved and those who can afford to lose money, but it is dangerous for most people.

TIP:

For the average investor, more conservative investment strategies are generally appropriate.

Professional guidance can be very helpful in developing a sound investment program.

TYPES OF INVESTMENTS

There are two broad categories of securities available to investors— equity securities (which represent ownership of a part of a company) and debt securities (which represent a loan from the investor to a company or government entity). Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.

Each type has distinct characteristics plus advantages and disadvantages, depending on an investor's needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities.

Stocks

The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a "share" of a company's assets. If a company is successful, the price that investors are willing to pay for its stock will often go up--shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed appreciation or "capital gain." The stockholder is also entitled to dividends, which may be paid out from the company. Investors, therefore, have two sources of profit from stock investments, dividends and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investors potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.

As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.

Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in a much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year while common stockholders reap the rewards of a great year.

Corporate Bonds

The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of "interest" each year, which is usually a percentage of the amount loaned.

Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond, if they hold the bond for the time period specified.

Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.

Government Bonds

The U.S. Government also issues a variety of debt securities, including Treasury bills (commonly called T-bills), Treasury notes, and U.S. Government agency bonds. T-bills are sold to selected securities dealers by the Treasury at auctions.

Government securities can also be purchased from banks, government securities dealers, and other broker-dealers.

Similar to corporate bonds, these bonds pay interest and the amount of principal at maturity. Some (viz., Treasury Bills) may not pay cash interest. Instead the bond is purchased at a discount and the interest is built into the amount the investor receives at maturity. Contrary to popular belief investors must pay income tax on U.S. government bond interest.

Municipal Bonds

Bonds issued by states, cities, or certain agencies of local governments (such as school districts) are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition. the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.

Municipal bonds are exempt from registration with the SEC; however, the MSRB establishes rules that govern the buying and selling of these securities.

Stock Options

An option is the right to buy or sell something at some point in the future. An option is a type of derivative security. There are a wide variety of these specialized instruments such as futures, options and swaps. Most are not appropriate for the average investors. The type of options with which we are concerned here are standardized, exchange-traded options to buy or sell corporate stock.

These options fall into two categories—

"Calls," which give the investor the right to buy 100 shares of a specified stock at a fixed price within a specified time period, and

"Puts," which give the investor the right to sell 100 shares of a specified stock at a fixed price within a specified time period.

While options are considered by many to be very risky securities, if used properly they can actually reduce the risk of a portfolio. Generally you buy a call option if you are bullish on a stock (i.e. you expect the price to go down). The price you pay is called the premium. You would purchase a put option if you are bearish on a stock (i.e. you expect the price to go down). If the stock moves in the right direction you can profit handsomely. If it doesn’t you lose the premium that you paid. Buying puts and calls is not a risky strategy, but selling puts an calls is. One exception is selling a call option on a stock you already own. This is known as a "covered call." This actually reduces the overall risk of your portfolio in exchange for you giving up some of your upside.

Mutual Funds

Companies or trusts that principally invest their capital in securities are known as investment companies or mutual funds. Investment companies often diversify their investments in different types of equity and debt securities in hope of obtaining specific investment goals. In a mutual fund you invest in the mutual fund which then invest in individual equity and debt securities. This relieves you of the necessity to make individual purchase and sale decisions. It also provides an easy way to diversify a portfolio. Rather than purchasing 50 stocks yourself, you can purchase one mutual fund.

Related FG: For more detailed information, please see the Financial Guide

INVESTING IN MUTUAL FUNDS: Time-Tested Guidelines.

INVESTMENT CONTRACTS AND LIMITED PARTNERSHIPS

Investors sometimes pool money into a common enterprise managed for profit by a third party. This is called an investment contract. Such enterprises may involve anything from cattle breeding programs to movie productions. This is often done through the establishment of a limited partnership in which investors, as limited partners, own an interest in a venture but do not take an active management role. Some of these securities have been issued in the past primarily for purposes of reducing income tax liability. Such opportunities are limited today. Care should be taken in investing in these securities since they can be illiquid and require a great deal of expertise. You should consult with your financial advisor regarding these types of investments.

REAL ESTATE INVESTMENT TRUST (REIT)

Real estate investment trusts are set up in a fashion similar to mutual funds. Instead of investing in stocks or bonds, however, REIT investors pool their funds to buy and manage real estate or to finance real estate construction or purchases. Real estate limited partnerships are also common. This is a way to get diversification from real estate investment without the headaches of property ownership and management.

ASSET ALLOCATION

Asset allocation is the process of allocating your investments among the broad categories of stocks, corporate bonds, government bonds, etc. It is extremely important in investment success. In fact, portfolio selection should generally be based on asset allocation, whether formal or informal. This process can be complicated, but computer programs are available to assist in performing the allocation.

Related FG: For a discussion of this very important concept, please see the Financial Guide

ASSET ALLOCATION: How To Diversify Your Assets For Maximum Return.

RISK VS. RETURN

One of the more basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. It is up to you to decide how much risk you can assume. Always keep in mind your current and future needs.

Risk

There are many types of risk. The one most people think of is market risk, which is the risk that market prices can fluctuate. If you have a short investment horizon, generally something less than five years, this risk is important since the market could be down at the time you most need the money. On the other hand, if you have a long time horizon, for example when saving for retirement, you may be unconcerned with market risk. The investment has the opportunity to come back prior to the time you need the funds.

Another risk, which many people don’t think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living. A bank CD for example might pay interest of 3% and have no market risk. Your principal does not fluctuate in value and you are insured against loss. However, if inflation exceeds 3% you will lose purchasing power.

TIP:

In general, prospective investors should avoid "risky" investments unless they have a steady income, adequate insurance, and an emergency fund of readily accessible cash.

TIP:

U.S. Treasury bills, notes, and bonds are the safest possible investments.

You need to assess how much risk you can tolerate. One easy way to measure this is how well do you sleep at night. If you lie awake worrying about your investments, you risk tolerance is probably too low for your current investment strategy. In general the longer your investment horizon the greater the amount of risk you can afford to take. Your financial advisor can also assist you in measuring your risk tolerance.

Risk can also be reduced through diversification. Rather than buying one stock, buy a basket of 20 to 30 stocks. This reduces your overall risk. You can also reduce risk by combining different investment types such as stocks, corporate bonds and government bonds. These securities are not highly correlated (i.e. they tend not to go up or down at the same time).

Return

Why would one want to take on more risk? Because it generally comes with a higher expected return. While stocks may have the greatest market risk, they have also provide that highest market return over the long haul. Stock returns have averaged between 10 and 11% since the early part of this century. Corporate bonds on the other hand have averaged between 6 and 7% and government bonds closer to 5%. As you can see the lower the risk the lower the expected return. You must balance the amount of risk you are willing to tolerate with the amount of return you expect to achieve. There is no such thing as a high return/low risk investment.

PLANNING TECHNIQUES

You should assess your current resources and future goals. This will assist you and your advisors in determining what rate of return is necessary to achieve your goals and how much risk you can tolerate. Here is a suggested checklist:

Assess your current financial resources. How much do you have to invest?

Assess your future financial resources. Do you have an excess of income over expenses that can be invested?

Determine your financial goals. How much money do you need and when do you need it?

Determine the rate of return you need to achieve your goals.

Determine how much risk you can tolerate based upon your time horizon and personal preferences.

Choose an appropriate asset allocation to achieve the desired risk/return relationship. How should you allocate your investment among the various classes of investments?

Choose the individual securities within each asset class. Which securities should you buy?

SECURITY SELECTION

Once you have decided what percentage of your assets should go in each asset class, you need to select the appropriate individual securities. You should consider the same techniques as in selecting the asset classes to invest in. For each security you must evaluate its unique risk and its expected return. There are a number of sources of information about specific securities that you can explore.. Generally, the most important of these for mutual funds and new stock issues is the prospectus, which is the security's selling document, containing information about costs, risks, past performance (if any) and the investment goals. Read it and exercise your judgment carefully, before you invest. You can obtain the prospectus from the company or mutual fund or from your financial advisor.

In the case of a mutual fund, there is also a Statement of Additional Information (SAI, also called Part B of the prospectus). It explains a fund's operations in greater detail than the prospectus. You can get a clearer picture of a fund's investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund must send you an SAI and/or its periodic reports. This process is time-consuming and requires a great deal of time and expertise.

Keep in mind that proper security analysis is extremely complex. Computer programs (the good ones are usually quite expensive) are invaluable in helping choose an appropriate portfolio; however, these programs require a familiarity with their use and an understanding of their limitations. Generally, if you do not have the time to perform the necessary analyses or the experience or expertise in security selection, you should consult with your financial advisor.

https://www.investopedia.com/articles/younginvestors/10/what-is-an-investment.asp#ixzz54MkFXaFk

https://www.entrepreneur.com/article/74184

http://fso.cpasitesolutions.com/Premium/IS/fg/fg-Investing.html

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