If you’re like me, you are excited about investing and want to start right away but there are a few things you need to do before you start investing.
Following the actions below will not only ensure you are ready to invest but will also help prevent you from failing as an investor.
Before you start building your financial wealth, you need to ensure you have good financial health! So how do we do that?
1. Establish an Emergency Fund
The Federal Reserve performed a survey that showed 44% of Americans would have a difficult time even affording a $400 unexpected expense.
Life happens and you can’t escape it. There will almost certainly be times when you need money and you need it fast for something unexpected. Here are some quick examples:
- The dog broke its leg (happened to my dog 8 years ago)
- A beehive was found in the attic (happened to my brother)
- Your son accidentally broke a neighbor’s window with a baseball
- A car’s wheel bearings went out (happened to me last week)
- The dentist needs to pull a tooth
- You found the perfect lightsaber and it costs $399
Ok, that last one’s not an emergency but you get the idea!
It’s obvious that emergencies happen but how you respond to them determines how well you can recover.
For example, let’s say you find a beehive in your attic. My brother would just go up there and remove it because he’s crazy like that. I, on the other hand, will gladly fork over the $500 it would cost to have it removed by a professional.
What would you do?
If you have an emergency fund of $1000 and decide to have it removed, the money comes out of the fund and the bees get removed from the attic. Then you save and build your emergency fund back up to your $1000.
Let’s say you don’t have an emergency fund. You still have options. You can borrow the money, you can place it on credit or you can live with the bees and just never go in your attic again.
If you have investments, there’s another option. Take out some of your investments to pay for the emergency. This may seem like a better alternative than credit and it probably is but let’s look at the risks.
Stocks (like all investments) have a certain degree of risk. In the short term, the stock market goes up and down and emergencies don’t care how well your portfolio is doing.
If your investment is doing well and you take the money out to fund an emergency then it’s not a big deal.
What if it goes down though? Over the long term, the investment would have probably gone up (statistically around 6-8% per year) but in the short term it could be down and now you took out a losing investment to pay for an unfortunate event.
That loss comes with pain. No one wants to lose money. Likewise, when you put something on credit, it comes with interest. Interest always seems to be underestimated but it will eat at your finances.
Having that emergency fund minimizes the pain felt when you pay for emergencies. It also protects you financially from interest and losing money in investments that were planned with a longterm mindset.
What If You Lose Your Job?
It’s the question everyone hopes to never have to answer but the reality is if you lost your job, chances are there will be some time when money is a little tight while you look to replace that income source.
This is why I recommend having enough in an emergency fund to protect yourself if you were to lose your job for 3-6 months.
This doesn’t mean you have to save enough for 6 months’ worth of paychecks (although it might, depending on your lifestyle).
I mean you must have enough to sustain your necessities for 3-6 months.
As stated earlier, the biggest reason for this is because once you start investing, you don’t want to be required to withdraw your investments at a time that you hadn’t planned on originally.
Check out our step by step guide on how to save for an Emergency Fund!
3-6 Month Emergency Fund Calculation
To determine how much your emergency fund needs to be, you should first add up all of your expenses each month.
Once you add up, multiply that amount by 3
and 6 to determine your 3 months and 6 months required amount.
Let’s make some assumptions for our case study:
Now that you know how much need to save, check out our step by step guide on how to save for an Emergency Fund!
2. Determine Your Net Worth
To determine your net worth, you must first determine your assets and liabilities. This is just a fancy way of saying figure out what you own and what you owe!
In order to determine your net worth, you need to determine what types of things that you have of value and what types of things of negative value.
You can do this on a piece of paper, or you can even do it on a spreadsheet.
Let’s Start With Assets.
Assets are things that you own that can be sold for money and have value. Examples consist of:
- your home’s market value (if you are a homeowner)
- your car (or cars)
- cash in your wallet
- cash in the bank
- investment property
- bars of gold that your grandfather left you
- anything else that you can think of that you deem valuable.
Line up your assets by their liquidity. Liquidity is a measure of an asset’s ability to be turned to cash. Cash is the most liquid because you already possess it and can use it immediately to buy and sell goods.
A home, on the other hand, is not liquid since it can take months to sell and convert to cash and even in the best cases require a waiting period known as escrow to transfer the funds from the buyer to seller.
An asset chart may look something like this:It gives you a nice convenient look at the total value of all of your assets.
Next, do the same thing with your liabilities
Liabilities are items that you owe money on and are legally bound to pay. Examples of liabilities are:
- Mortgage Loans
- Car Loans
- Student Loans
- Personal Loans
- Credit Cards (which are essentially cash loans for every swipe)
This chart is not nearly as fun to come up with but is equally important.
A liability chart may look something like this:Net Worth = Assets – Liabilities
Lastly, subtract your liabilities from your assets to determine your Net Worth. Your Net Worth is your basic measure of wealth and shows what your value as an individual is after taking account of all assets and liabilities.
Here’s another illustration to help out.In the above example, the individual’s net worth is almost 70,000 dollars. If this person were to sell all of their assets to pay off all of their liabilities, they would be left standing with an envelope with $70,000.
3. Pay Off High-Interest Liabilities (aka Debt)
Look back at the liabilities that you listed. Some of your interest rates are undoubtedly high. What’s considered high? Well, since the average yearly appreciation of the stock market is between 6-8%, I would say anything above that is high.
All credit cards would fall into this category.
If you can pay off your debt, two things will happen. First, you will be in a better position to invest later. Second, you will save yourself from the interest that you would have accrued over that time.
Let’s say you have a $2,500 credit card with 10% APR. Every year that the balance remains, charges $250.
If you pay it off, you save yourself $250 every single year from that point on. Guaranteed! You’re literally burning money!
If you invest the $250 and it goes up 8%, you end up with an investment worth $2700 ($200 increase). Maybe.
You could also lose money and end up down 6%. That would leave you with an investment worth $150 less or $2350. Subtract the credit card interest and you are down for the year to $2100.
It’s not too hard to see how this could be damaging to your financial portfolio and overall well being. Don’t just take my word for it!
Ok, I think the point has been made. If you can pay down your higher interest liabilities, you will be glad you did in the end.
4. Participate in Your Workplace Retirement Plan
This step is for those that have the option to participate in a retirement plan that offers employer matching contributions.
If your employer doesn’t offer matching contributions, you may still want to invest in a 401k first for tax reasons or simply because it’s an easy way to invest for your future and is less tempting to draw from when you need extra money.
If your employer does matching contributions, invest at least the minimum amount to get the maximum contributions. For example, if your employer matches up to 6%, invest at least 6% since that contribution is free money.
I am always amazed when people talk to me about investing but they don’t utilize the free money their employer is willing to give them to invest. If you put in $40,000 a year, and your employer matches your contribution up to 6% that’s about $2400 of free money each year.
That means your $200/month contribution doubles in value instantly when it’s matched. That’s 100% return before you even enter the market. How’s that for a good return?
5. Determine Your Investing Goals
The last thing you need to do is determine what your goals are with investing. How long do you want to invest in? If you only plan to invest in the short term, you’re better off just saving your money or investing it in fixed-rate low-risk assets like CDs, a Money Market Account, or a traditional savings account.
If you have time to let your investment grow, you may like to invest in higher-risk assets such as stocks since they will offer you a higher reward over time.
Here are some general ideas to get started:
- Short Term (1-2 Years) – Saving by placing money in Savings Account, Money Market Account, or CDs
- Medium Term (2-5 Years) – Saving or Investing in low-risk stocks (Blue Chip or Large-Cap Stocks)
- Long Term (>5 Years) – Investing in a mix of Small-Cap, Medium-Cap, and Large-Cap depending on risk tolerance.
I made this complex graph to show you how risk correlates to time:All kidding aside, if you try to invest in stocks with a short time horizon, you risk losing a large portion of it if the investment simply has a bad year. If you invest with a long-term approach, over time the average annual return should be positive and build your wealth.
Most investors buy stocks with the mindset that they are buying into companies. With this mindset, they know that when they buy stock, they will be holding it for at least 5-10 years.
Congratulations! You now know the five things you need to do before investing. By taking action on the above list, you will be setting yourself up for success when it comes to investing and your overall financial health will improve immensely.
After you complete each of these five tasks, you will be able to sigh with relief knowing that you have done everything in your power to not only be ready to invest but also to reduce the risk for your financial future!
Which of these actions do you still need to take?
Once you are ready to start investing, check out my comprehensive guide on how to buy stocks for the first time!
Eric Baglio has been investing for over ten years and learned a lot of valuable lessons along the way. He has helped numerous people start investing on their own and founded Let’s Start Investing to help anyone willing to learn how to build wealth. His favorite brokerage is Webull and his favorite stock advising service is Motley Fool Stock Advisor.