When Should You Start Investing…[and How]?
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Today's post is by Ed Canty, a Financial Planner and personal finance blogger. His blog investingsimple.blog covers a variety of topics around personal finance and investing.
Everyone always tells us how important it is to invest our money. My father always said, “Investing your money will ensure a prosperous future and allow you to live a comfortable life when you stop working.”
But not many people tell us when we should begin investing. When is the right time to invest? How much should I invest? How do I get my finances in order before I pull the trigger and purchase my first investment?
In this post, I'd like to explain a few basic financial planning concepts that many of us investors use before deciding to invest our money. In doing so, we can ensure we have a degree of financial stability before we tie up a portion of our net worth in an investment.
Covering Living Expenses Before Investing
By far the most important step before we begin investing is to have sufficient funds to live off of. This includes all our fixed expenses such as food, rent, utilities, and other necessities. As a financial advisor, it is alarming how many people who live paycheck to paycheck and don't maintain sufficient funds to live off of.
A balanced financial lifestyle is also crucial. It is important to make sure you are living within reason, but not sacrificing your comfort or experiences with friends and family in order to save a minimal amount of money.
You can take this with a grain of salt because it is great to live a frugal life, but sacrificing life experiences to save money is not the point. A balance of saving our money and spending it wisely is how we maintain a healthy lifestyle. This balance is different for everyone.
Have an Emergency Fund Before Investing
I'm sure many of us have heard about an emergency fund or a financial safety net. This is the account where you will want to save cash for unexpected life events. When your car breaks down, your water heater breaks, or you have an unexpected medical bill, you will be happy you have an emergency fund.
Everyone lives a different lifestyle and has different income levels, so it makes sense that one person's emergency fund will be different than another's. It is recommended that we save 3 to 6 months of monthly non-discretionary expenses in your emergency fund.
These are all your necessary expenses such as rent, food, and transportation. All these expenses are the necessities that you absolutely need in order to live. This way in the rare case you lose your job, you will have a safety net and enough money to live off of during the months you are looking for a new job.
It is important to note that an emergency fund is for emergencies. I know this sounds extremely obvious, but we must understand that it is not our stockpile for large purchases or the way we fund a down payment on our house. This is the money we need in case of an unexpected life event.
It is important that we maintain a liquid emergency fund. What does this mean? We need to have the ability to get cash in a reasonable amount of time to fund an emergency event. This is why you should be cautious about investing your emergency fund. The best place to park your emergency fund is in a bank account or liquid money market account where you can earn a small amount of interest, but not sacrifice liquidity.
Investing your emergency fund can be risky. Another way to look at this is, say you invest your emergency fund in a portfolio of stocks. How is it possible for anyone to have any sort of investment time horizon for an unexpected life event? At any random point, you could be forced to sell your positions and pay for an emergency. It is extremely difficult to earn a return on an investment when you have no time horizon.
One other strategy I suggest for emergency planning is to have an emergency credit card available as a temporary source of funds. Your credit card can serve as a means to make an immediate purchase while you transfer the cash out of your emergency fund. Once you have your cash then you can pay off your credit card balance. This way you have an instant source of funds in the case of an unexpected emergency.
Should You Pay Off Debt Before Investing?
The next step after you have built up an emergency fund is to begin paying off your debts. Now there is a difference between good debt and bad debt and it is not solely based off of interest rates. Bad debt does not necessarily mean it was bad spending, but that it is bad debt to keep holding on to.
Everyone looks at debt differently, so this may apply to some people, but not all. Bad debt can be considered debt that is not absolutely essential to living your everyday life. The bad debt is the high credit card balance or the consumer loan you took out last Spring to fund the purchase of your new boat. Bad debt is usually fueled by consumption rather than necessity.
Let's take the boat loan, for example, this is a debt you should make a high priority to pay off. Few people require a boat to live their daily life. Now I am not saying that you should not buy a boat, but rather you should have a game plan for paying off the boat loan.
Not all debt is bad, taking out good debt such as certain mortgages or car loans can be a perfectly fine financial decision. In most cases, these are necessary items to live your everyday life. A mortgage can help you afford an expensive but necessary asset, by paying for it over a long period of time. In the case you purchased a house or car you can't afford, or have an absurd interest rate, then you may want to re-evaluate your loan or consider selling.
Good debt can be fine to hold on to while you begin investing, but make sure you have a plan to pay these debts down as well. The whole point is that you don't want to begin investing when you have significant debt. By paying down the balance on your 26% interest rate credit card, you are instantly earning a 26% return on your money, that's unheard of!
It is important to get a firm grasp on all of your debts, good and bad, before you begin investing.
Time to Invest
Once you have built an emergency fund and assessed your debt, it may be time to begin investing. It is important to understand your investments as well as gain an understanding of some basic investing fundamentals before you purchase your first investment.
Many investors create investment policy statements which cover factors such as your risk, time horizon, and overall investment goals. It is extremely important to have a game plan before you begin investing. This way you have a course of action before you begin risking your money.
When I meet with a client who is ready to invest, we typically begin by addressing their retirement accounts. Retirement is very boring for people to talk about, especially when they are young and retirement is almost incomprehensible. Retirement is inevitable for most of us, so it is crucial we address this topic when building a financial plan.
If you have a retirement plan at work then you may want to contribute, especially if there is a match. Personally, I contribute up to my employer match which is dollar for dollar up to 3% of my salary. You can always contribute more, but at least try to contribute up to the match to get your free money!
If you have no retirement plan at work then you may want to contribute to a Traditional IRA or Roth IRA. This stands for Individual Retirement Account (IRA). You can set up IRA accounts at practically any brokerage nowadays. There are income phase-outs and contribution limits for IRA's so make sure you are eligible before you contribute.
These tax-favored accounts will help you build up their balances faster, or in the case of a Roth IRA will allow you to have a large stash of tax-free money at retirement.
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Once you have satisfied your retirement plan contributions then you may want to begin funneling money into a regular taxable brokerage account. These are regular accounts that incur taxes in the same year you realize a capital gain or receive a dividend or interest payment. You will pay taxes on this income when you go to file your annual tax return for the year. There are no contribution limits to regular brokerage accounts.
To Wrap it Up
There are many different methods to get your ducks in a row before you begin investing. Maintaining sufficient funds for living expenses, having an emergency fund, and paying off debt are some of the most important factors to tackle before you begin your journey as an investor. Everyone has a different situation and lifestyle so this guidance may not apply to all investors, but for many, it is a good way to begin prioritizing your finances.
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