4 terms every investor should know

This is about your ability and willingness to accept investment risk. Ability and willingness can be different. Let’s say you're investing for retirement in 25 years. This could mean you have a high ability to take risk because you have a long time to pursue gains and recover from losses. However, your actual willingness to accept risk might be lower, especially if you don't like seeing a lot of ups and downs in the value of your investments. When your ability and willingness to accept risk are different, go with the lower of the two, as it's more likely you can stick with this approach through good and bad times. Risk tolerance is a good starting point to think about investments, because it puts the focus on a process you can follow over the long term.

This is how you divide your investments between different assets. The most important assets in a typical investment portfolio are stocks, bonds and cash. To set this asset allocation or investment mix, consider your risk tolerance as an investor. If you have a high risk tolerance, you may want to consider an assertive investment mix — for example, mostly stocks and the rest in bonds and cash. If you have a low risk tolerance, a cautious investment mix might be more appropriate — for example, mostly bonds and cash and the rest in stocks.

The decision about asset allocation is likely the most important decision you will make as a long-term investor. It matters a lot more than how good you are at picking individual investments or how good you are at timing when to invest.

Here's why this decision matters. Imagine you have the world's best investor picking stocks for you, but you only have 1% of your portfolio in stocks. Compare this to the simple approach of investing in a stock index fund but putting 60% of your investments in stocks. The simple approach would likely have a lower return, but it's weighted at 60% rather than 1% in the portfolio, so the overall impact of owning stocks is much greater.

If asset allocation is about how much to invest in assets such as stocks, bonds and cash, diversification is about how much to put in each investment. For example, when it comes to stock investing, you could invest all your money in a single company, but this would be very risky because a single company can lose a lot of value or even go bankrupt. To deal with this risk, investors diversify. One of the simplest ways to do this is to invest in a mutual fund or exchange-traded fund, which can give you exposure to a wide range of different stocks in a single purchase.

You may also want to consider spreading your stock investments across different regions of the world, such as Canada, the United States and international markets. With a broad selection of stocks, you reduce the risk of your investments being hurt by a drop in a single stock, industry or country. Diversifying also applies to bonds and cash but is particularly important for stocks because some stocks can lose a lot of value when markets take a turn for the worse.

This is the amount of money you gain or lose on your investment over time. With stocks, there are two main ways to earn returns.

The first is through a change in the stock price. If you bought a stock at $50 and after a year the price went up to $55, your investment would have a 10% price return.

The other way investors earn a return on stocks is through dividends, which is a portion of the company’s profits that it pays out to shareholders. In our example, if the company also paid out $2 in dividends over the course of a year, this would amount to a 4% dividend yield, based on the original stock price of $50. In this example, the total return is the price return plus the dividend yield: 10% plus 4%, for a total return of 14%.

News headlines often focus only on the price change, while long-term investors should focus on the total return. Prices are always moving up and down, but dividends tend to be more stable and they can make up a big part of the total return for long-term investors in the Canadian stock market. Long-term investors should also focus on the return after inflation. In addition to fees and taxes, the return after inflation reflects how much the purchasing power of your money has changed.

Your investing journey can last for decades, sometimes longer than your career. An advisor can help you apply these investment concepts to your personal investment strategy, so your money works as hard as you to achieve your long-term goals.