Preparing for a changing financial marketplace
Exchange-traded funds, equity-indexed annuities, weather derivatives—these are just a few of the investment vehicles that are available in a large, complex, and fast-changing marketplace. Given the recent attention devoted to the stagnant economy and high-profile investment scams, developing a personal financial plan—particularly an investment plan—can seem daunting. There's more to consider in the financial marketplace than just stocks and bonds. But how can we prepare students to participate in this market when some of today's products could be obsolete tomorrow and others have yet to be created?
While there is much to learn about the financial markets, introducing students to a few basic principles of investing helps to provide a foundation from which they can become lifelong learners. By understanding how investment instruments can vary according to their risk, interest rate, and maturity, students can develop a framework that will enable them to grasp how different types of financial products work and which may be best suited for them at various points in their lives.
Risk. While it's a cliché that risk comes with reward, it's important that students learn how to apply this basic lesson. The first step is learning about the differences in risk and volatility among conventional instruments like savings accounts, Treasury bonds, and mutual funds. The next critical lesson is how different levels of risk are appropriate to take at different times, depending on one's age and financial goals. Understanding differences in risk is also a prerequisite to learning about diversification.
Diversification. Research has shown that an investor reduces the overall level of risk in his or her portfolio by spreading investments across several different kinds of assets that have varying levels of risk and return. Asset classes include individual stocks, mutual funds, long-term and short-term fixed income securities, commodities, certificates of deposit, savings accounts, money market funds, and cash. In general, the longer the time horizon that an investor has, the more risk he or she can tolerate. Students should have a general idea of the risk and potential return of each kind of investment and whether that level of risk and return is appropriate for their specific situation.
Compound interest. Even students who have a handle on why financial institutions pay interest and how it functions as a reward for risk may not know exactly how much they can earn if they put money away in an interest-bearing account. They may also not appreciate the true cost of borrowing once the compounding of interest kicks in.
Maturity. Ensuring that students learn about variations in maturity periods gives them a fuller understanding of how instruments without early withdrawal penalties are better geared for providing income, while others are designed to build wealth more quickly.
As students begin to understand and investigate these basic concepts about financial instruments, they should be aware that banks and other institutions may use marketing hype to make some instruments look more attractive than they really are. Students should verify information about how certain features work with impartial sources such as the Federal Reserve.
Ultimately, if we can encourage students to think about their financial goals and give them the tools to ask the right questions while pursuing those goals, they can be better prepared for changes the marketplace has in store.
By Al Melchior, economic and financial education specialist, Miami Branch