What is a good investment?

Types of investments

Before you can choose an investment that’s right for you, it’s essential to understand the different types of investments and how they work.

Understanding risk in investments

All investing involves some measure of risk. In general, the higher the investment risk, the higher the potential reward (or loss). There are several risk factors to note for any given investment, including:

• Economic risk
• Political risk
• Competition risk
• Industry risk

These risk factors can cause an investment to drop in value, sometimes significantly. You should consider them before choosing an investment.

“Risk evaluation is an art as much as it is a science,” said James Allen, certified financial planner and founder of Billpin, a personal finance blog. “It's about understanding the potential downside and whether you can stomach it.”

Researching a company stock or fund can help you understand the risks involved in a given investment. Then you can choose whether or not you’re comfortable taking those risks to reap the potential returns.

“I look at factors like the company's financial health, the stability of the industry it's in, and the overall economic environment,” said Allen. “For bonds, the creditworthiness of the issuer is key. Mutual funds and ETFs require a look at their portfolio composition and the track record of the fund manager. But remember, high risk can mean high reward.”

It’s essential to understand your own risk tolerance, meaning your ability to withstand volatility in your investments without panicking or selling early. How comfortable you are with taking risks will inform your investment strategy and which investments to choose.

For example, If you have a high tolerance for risky investments, you can invest in more volatile assets like individual stocks. If you are risk-averse, you might stick with lower-risk investments like Treasurys and bonds.

Time horizon and investment strategies

Investing requires some basic goal-setting to determine how long you plan on staying invested. This means spelling out your financial goals and putting a timeline around when you want to achieve them. With those dates in mind, you can now choose investments that best fit your goals.

Here are a few investment time horizons to consider, along with the types of investments for each.

Diversified Portfolio

If you’ve ever heard the saying, “don’t put all your eggs in one basket,” it’s a perfect way to describe diversification. Spread your investments among multiple accounts and assets to protect yourself from risk while still getting a solid return.

Here are a few ways to diversify your investments:

Asset classes

An asset class just means the type of investment instrument(s) you want to pursue. There are over a dozen asset classes to invest in, and you can choose a mix of them to diversify your holdings. This includes stocks, bonds, commodities, Treasurys, fixed income and real estate.

Investment sectors

Within the stock market itself, there are different sectors you can invest in, including health care, utilities, finance, materials, real estate, information technology and industrials. Owning stocks in several investment sectors adds another layer of diversification to your portfolio.

Investment accounts

There are many different types of investment accounts that can help you save on taxes or have more flexibility. This includes:

• Standard brokerage accounts
• Individual retirement accounts
• Health savings accounts
• Workplace retirement accounts

Spreading your investments among these accounts can help lower your tax burden and allow you to access funds early if needed.

» MORE: Capital gains vs. investment income: how they differ

Fees, budget and returns

There are costs to investing, and it’s important to understand how fees fit into your overall investing budget and returns. While some apps claim you can trade stocks for free, long-term investing typically involves fees that can impact your overall financial plan.

Yes, you can buy individual stocks without paying a commission to many stockbrokers, but owning only stocks isn’t the best long-term investment plan. There may be fees included to invest in mutual funds, index funds or other investments. Also, if someone else manages your investments for you (a financial planner or robo-advisor), you’ll pay a management fee on top of any fund fees.

Calculate the cost of any fees in your investment plan. For example, if you’re paying a 1% fee to your financial planner and the funds in your plan have a 0.25% average annual fee, you need to lower your expected returns by 1.25%. The higher the fees, the larger the impact on your investments, so plan accordingly.

Additionally, make sure most of your investing goes toward long-term goals in a diversified portfolio. While speculative investing in things like individual stocks and cryptocurrency can be exciting, you shouldn’t invest more money in those investments than you can afford to lose.

» MORE: Best investment apps for beginners

Market research and analysis

Before choosing an investment, you need to do your own research and analysis to make an informed decision. This means diving into the details of the investment, including the market and sector it’s part of and its historical performance. While past performance doesn’t guarantee future results, it can tell you how the investment has grown over the years.

Research might include:

• Reviewing pricing charts
• Reading business news stories about a company or fund
• Diving into the financials of a specific company
• Reading through its public disclosures (such as a 10-K form)
• Reading analyst reviews of a specific investment choice

Doing your homework beforehand can increase your chances of picking the right investment for your goals.

Psychology and emotions in investing

Investing your money is emotional, especially when you see your investments drop in value. But investing should follow a rational plan based on your research rather than emotional decisions based on your feelings about an investment at a given moment.

Ask these questions to help you understand how you feel about money on an emotional level:

• Do I hate losing money more than I enjoy making money?
• Can I handle uncertainty, or do I need a sure thing?
• Can I make changes, or do things need to stay the same for me to feel comfortable?

The answer to these questions can help you learn how you’ll react when markets change, and you can put a plan in place to avoid making rash decisions. When emotions are high, you can avoid making poor choices because your plan has already dictated your money decisions ahead of time.

You can also avoid poor decisions by enacting these few rules:

• Require a waiting period before making any significant money decisions (several days to a week)
• Run your decision by a trusted professional to help you understand the total impact
• If your decision changes your investing plan, ask yourself if you no longer believe what you used to when you made the plan in the first place

Bottom line

There are thousands of investment options to choose from, and the best investment is one that fits your investing goals, timelines, risk profile and budget. Whether you’re just getting started with investing or want to diversify your holdings, you’ll want to work with a trusted broker that offers the type of investments you’re looking for.

Make sure to do your research and create a plan for yourself before you choose your next investment.