• Got it Pass Team

Investing Basics Step by Step: Principles, Objectives & Constraints

Updated: Aug 18, 2020

Investing is something every single person should want to learn about, and you may already be investing and not even know about it. There is more to investing than just playing the stock markets. Your retirement is an investment. Savings bonds are an investment.

If you can build a sustainable future with these hands-off models, imagine what you could do for yourself by learning the fundamentals to investing and taking a more hands-on approach to both your finances and your future! Investing can seem overwhelming in the beginning, but once you’ve got a grasp of the basics you can almost certainly control how comfortable your future will be.

Investing Basics: Asset Allocation, Diversification, and Rebalancing

We’re just getting started, so now is a good time to repeat the age-old cliche that you’ve heard a million times: Don’t put all of your eggs in one basket. And there’s a good reason why this gets repeated often!

What if all of your investments are in the stock market and the economy takes a huge crash like it did on March 16th, 2020 in the midst of the Covid-19 pandemic? Or, what if all of your investments were tied up in real estate and the housing market crashed again like it did in 2008? Diversifying your investments helps you weather the ups and downs of the economy.

Asset Allocation

There are many different asset classes that one can invest in: stocks, bonds, mutual funds, commodities, metals, private equity, just to name a few. Asset allocation involves dividing your portfolio up between different asset classes based on a number of factors:

● Time - How long do you plan on investing into these specific assets?

● Risk - Are you willing to tolerate some risk for an increased reward?

There are three main asset classes that even the top investment advisors recommend that allocate across. Stocks, Bonds, and Cash.

Stocks - We all know what stocks are, when buying a share of stock you’re buying a piece of a company. These carry the highest risk amongst the three main asset classes, but also have the highest potential for reward. Stocks can be very risky, especially for short-term investing, but have proven to be safer in the long run.

Bonds - Bonds are typically not nearly as risky as stocks, but their returns are modest when compared to those that can potentially come from stocks. These are a great way to balance out your portfolio towards the end of your investment cycle for some safe returns.

Cash - Now, we don’t mean actual, physical cash. We’re talking about cash-equivalent investments. This can be a high-yield savings account, a certificate of deposit, money market accounts, or treasury bills. This is generally regarded as the safest class of investments and that safety is reflected in their low return rates.

There are many other asset categories out there, but we’re just covering the three main asset classes to help illustrate the basics.


Whenever you invest across multiple asset classes, you are diversifying your portfolio. The idea behind this is that should one class of assets lose value, the other ones will pick up the slack. For example, the value of gold will historically rise as the value of the dollar drops. For this reason, many investors buy up precious metals in order to hedge against inflation.

Diversification goes beyond just spreading your investments across different asset classes. Many investors choose to diversify within asset classes. For example, when investing in the stock market, you may wish to buy stocks from numerous companies in the oil and natural gas sector, and you may wish to also buy stock in the green/renewable energy sector. The value of one may drop but the others may rise as a result.


Whenever you rebalance your portfolio you change your assets around to stay on track with your original goals, or you rebalance it out with your original asset allocation. Over time, one class of assets may grow faster than anticipated, or one may grow much slower. If any of the assets are out of focus from your original investment goal, you may wish to re-allocate them.

Investing Basics: Investment Objectives - Income vs. Growth vs. Preservation

One of the main factors a beginning investor needs to decide on are their short-term and long-term goals. This will help you identify your investment objectives. Now, we need to be realistic here, you can’t just say “I want to make as much money as possible, as quickly as possible, without any risk.”

Typically, investments fall under two categories: Income and Growth. The purpose of an income investment is to provide income over the life of the investment. This can be anything from a stock that pays dividends to a rental property.

A growth investment exists for the sole purpose of growing the capital that was originally invested. These are also the types of investments that take advantage of compound interest. Your 401K or IRA would be a growth investment.

A third investment category, known as Capital Preservation, aims at preserving the original capital and to prevent loss in the portfolio. These are done with inherently safe investments, like treasury bills or certificates of deposit.

Investing Basics: Investment Constraints

There are certain factors that may limit your choice in investments, these are known as investment constraints. The constraints may be external, or out of your control. Or, they may be an internal constraint, something you may have a problem with. Let’s take a look at some of the more popular investment constraints.

1. Liquidity - Having your investment easily liquidated can be a make-or-break decision for certain investors. Not everyone likes the idea of having their money tied up for long periods of time, or the idea of facing fees and penalties for accessing their investment early. Although, illiquid investments traditionally earn more over time.

2. Taxation - Different investments will be taxed differently. A Roth IRA and a Traditional IRA are taxed differently. You may want to pay taxes now on your contributions while they’re lower because of the economic slump, rather than paying taxes in the future when you withdraw from your retirement fund and taxes are inevitably higher.

3. Risk Tolerance - A 25 year old fresh out of a graduate program earning 6 figures probably has more room to risk playing with risky and volatile stocks than someone who is 5 years away from retirement and simply wants to preserve their portfolio as much as possible. How much you’re willing to risk will determine the types of investments you make.

4. Time - Using the same example as above, that 25 year old has got all the time in the world before they hit retirement age. They’ve got time to take chances in hopes for a greater return in the long run. Someone who is 57 years old doesn’t have that same amount of time afforded to them and, as such, will likely have a much different portfolio.

5. Legal - There are even legal issues that come into play when trying to decide on different investment classes. You can’t just say you’re going to retire early by dumping $20,000 per year into an IRA. There are federal laws in place that mandate how much you can contribute. That’s also a great (and very simplified) example of a legal constraint.

6. Personal Choice - Many investors avoid certain investments based on personal, moral, and ethical choices. You may only buy stock in companies that make use of green energy. Conversely, you may avoid investing in some company that has an LGBTQ spokesperson. It is your right as a citizen to choose exactly how your money is invested.

Investing Basics: Suitability

The suitability of an investment is how appropriate it is for the investor in terms of their willingness to take a risk, as well as their short-term and long-term personal goals. Suitability also described the investor’s ability to safely make this investment.

For example, if you’re living on a $40,000 income, have owned your home for 8 years, and want to make a $100,000, super-risky investment that involves you tapping into the equity of your home and taking our personal loans, then your suitability for this investment is non-existent.

If you’re looking for safe, long-term investments to help you retire in 30 years, and your broker recommends dumping 80% of your retirement fund to invest in some hot new startup, then he’s recommending something that’s not exactly suitable for you.

Suitability is arguably one of the most important factors when it comes to making investment decisions. Does this investment fall in line with your personal goals? Can you safely afford to make this investment? These are just some of the questions that pop up when it comes to determining the suitability of your investment.

In fact, suitability is so important that FINRA, the Financial Industry Regulatory Authority, has rules in place that all of it’s broker members must follow when it comes to the suitability of the investments for their clients.

That’s right, your broker has a set of rules they must follow when determining the suitability of an investment for you. These rules are based on your investment goals and objectives, your tolerance for risk, your income, your net worth, your age, your tax status, your needs for liquidity, and the current state of your other investments. You can read more about FINRA Suitability to learn more about how and why they exist

Even if you’re handling all of your own investments, it would benefit you to go read over the FINRA suitability guidelines that brokers must follow. This will give you a better understanding of how you can properly decide which investments may be right for you as it goes way beyond simply asking yourself “Can I afford this?”

Investing Basics: Risk vs. Return Tradeoff

A basic principle of investing is that the higher the risk, the higher your potential return should be. Because of this principle, investors should typically associate low levels of risk, uncertainty, and volatility with low potential returns in exchange. Higher levels of risk should typically equate to a potentially higher return or reward. Based on the rule of this tradeoff, you may have to take some calculated risks in order to achieve higher profits and returns on your investments.

Calculating your risks should have you consider, at the very least, your risk tolerance, your short-term and long-term goals (ex: how long until you retire), and your ability to replace any funds that may be lost when taking part in a risky investment.

The risk vs. return tradeoff can apply to individual investments or it can apply to your entire portfolio. You can have half a dozen different assets in your portfolio, but make a risky stock purchase. Or, you can invest in an entirely risky asset class. These calculated moves need to be made very carefully, lest you both lose money and miss out on returns you could have made with safer investments.

Risk: Growth or Preservation?

Another key factor when determining whether or not an investment is too risky for you to make goes back to what we mentioned earlier about the different types of investments that will either grow your principal amount, or preserve it.

Investments that preserve your principal are often seen as extremely low risk. Treasury notes, for example, essentially have no risk at all. You can put a $10,000 principal into a treasury note and that $10,000 will absolutely be waiting for you 10 years from now. As a result, the returns are relatively low. Here in May of 2020, some treasury notes are paying less than a single percentage point of interest. When the economy is booming, you still may never get more than 3%. But they’re safe!

Those that want to grow their investment principal will incur some risk along the way. Even with an IRA or 401K, you will see some risk. Your retirement accounts will change with the economy. However, over time, they’ll probably yield more than treasury notes would.

Investing in the stock market comes with greater risks, you’re not guaranteed any sort of returns with traditional stocks. However, this risk leaves you with room to take in a potentially greater reward. Even investing in stocks that pay out dividends still come with some form of risk. There is no guarantee that the company will be successful a year from now, nor is there a guarantee that the company will even exist, regardless of their size (does anyone remember Enron?)

As we mentioned earlier, if you’re young and just getting started, you probably have room to take some calculated risks as you will have plenty of time to make up for any potential losses. Someone who’s just a few years away from retirement should simply want to preserve what they’ve got, even if it means earning some paltry 0.65% return.

Investing Basics: Time Horizon (Is longer always better?)

Your investment time horizon is the number of months, years, or decades you need to achieve whatever your financial goals are. Another way to look at it is by figuring out how long you can have your money tied up in an investment before you need that money back. There are three lengths of time that often come into play with time horizon periods.

Short-Term Time Horizon - Saving for a down payment on a home. This takes the average American about 2-3 years to do and, though that may seem like a long time, it’s a very short period of time in the world of investing.

Medium-Term Time Horizon - Saving up for your child’s (or children’s) education. This is usually done over a period of 15-18 years.

Long-Term Time Horizon - The most common example of a long-term time horizon is saving up for retirement. You essentially do this throughout your entire adult life. (Well, at least you should be.)

Your time horizon should show you both how to invest originally, and how to reevaluate your investments over time. Let’s take a look at a hypothetical scenario of what can go wrong if you don’t consider your time horizons:

At 25 years old, a young man has finished his Master’s degree and gets an amazing engineering job with Boeing. He decides to take part in Boeing’s employee stock ownership plan. Over the next 30 years, his twice-per-month payroll deductions mixed with the employer matching contributions mean he’s got an amazing number of shares in Boeing.

It is now time to retire and, because of decades worth of growth, his only retirement is in the form of employee stock ownership. The 30 years of bi-weekly contributions and employer matching means he’s built up a nice little nest egg. As retirement approaches, multiple Boeing aircraft see serious malfunctions that cause a devastating number of casualties (again, hypothetical!) and is a disaster all around. Contracts get cancelled, military and private airlines both vow to never do business with Boeing again, and their stock absolutely TANKS.

Now instead of a comfortable retirement, our engineer will have to either live very modestly, or work well into retirement. Can you see what went wrong here? The time horizons changed. At ages 25, 35, 45, he could have taken a hit on his retirement nest egg and found a way to bounce back. As he got closer to retirement age, his retirement was no longer a long-term horizon. Because his time horizon changed, he should have readjusted his portfolio from growth mode, to the preservation mode we talked about earlier.

Investing Basics: Emotional Investing

We’re going to leave you with one final tip here: Do not trade or invest emotionally! The psychology behind emotional investing follows two main points. Buying out of greed, or selling out of fear. Not only can this cause irreparable damage to your portfolio, but when enough people do it at once it can cause damage to other peoples’ portfolios as well.

Do you know how many people completely cashed out in mid March with the Covid-induced dive the stock market took? Many of them had been saving and investing for decades, only to cash out when the market was at its lowest point in a long time. With their investments now liquidated, they missed the recovery days that would have started to even their investments out from that original loss. They traded emotionally out of fear, and now they’re struggling.

Let’s look at it from another point of view: Greed and the 2000 dot-com bubble. As internet startups were taking the market by storm, many investors saw this as a way to get rich quickly. There were so many accounts of retirees liquidating their assets and dumping it all into dot-com tech stocks

I’m sure you can see where this is going. That dot-com bubble burst, leaving many people financially inept and many retirees looking for a part time job to supplement their social security income. They traded emotionally out of geed, and they too ended up struggling.

Hard-working, everyday citizens are putting their money into investments, hoping for modest short-term returns, or to achieve long-term retirement goals. It’s hard for them to watch their hard-earned money seemingly dwindle down every time the market takes a dip. But studies show you are 3x more likely to be upset from a dip in the market, than you are to be happy from a market jump.

Investing needs to be done solely with facts and logic. Do not let greed or fear get in the way, or your goals may be tarnished. Sure, you may get lucky once or twice, but nobody is lucky enough to sustain a portfolio that’s based solely on emotional trading. Statistics say that you will eventually lose out (and it may be big!)

Investing without getting your emotions involved is much easier said than done. If you have trouble understanding your own risk tolerance, then you should either be investing small while you learn more about how the market works, or leave the investing up to the professionals. Although we certainly recommend you keep on learning, a little more knowledge never hurt anyone!

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