Investing in stocks has never been more accessible.
Online brokerage firms make it possible to start buying equities in record time.
However, being unprepared is very dangerous.
Here are 5 things to do before investing.
1 – Build an Emergency Fund
Life is full of emergencies: A car breakdown at the end of the month, a job loss or non-refundable medical expenses lead to unexpected expenses which you did not budget for.
An emergency fund consists of savings earmarked to cover these unfortunate scenarios.
In a perfect world, everyone would have at least 6-12 months of living expenses saved up in an emergency fund, but it’s hard for the average person to save that much. Thus, you should aim to save at least 3 months worth of living expenses. if you earn $2000 a month, your emergency fund should have $6000 on it.
Since it’s very tempting to spend a large sum of readily available money, you should seriously consider placing this money on a dedicated savings account.
Contact your bank and ask them if they can open a high interest savings account for you. These accounts generally offer 1-2% interest a year – which is negligible compared to the stock market’s returns – but this emergency fund is a savings nest, not an investment. Let the 2% protect this money from inflation and forget about it until you really need it.
Start building your emergency fund right now. The last thing you want to do is cash out your long term investments to pay for something you could have anticipated.
2 – Budget
Long term investing requires financial discipline, patience and self-sacrifice.
Becoming a successful investor requires knowing how to manage your finances.
In a nutshell, managing your finances means spending less than you earn and investing the surplus. There’s no two ways about it: the easiest way to track and control your spending is to make monthly budgets.
If you don’t know how to budget, start off by using the simple 60/20/20 method:
– 60% of income is used to pay for living expenses (rent, food, utilities, insurance, phone)
– 20% of income is used for discretionary spending (eating out, vacations, shopping, partying)
– 20% of income is used for savings and investments.
To make you budget, create a table with two columns, income and expenses:
– Income consists or all money coming in; salary, dividends, rental income, etc
– Expenses is all the money going out:
-> Fixed expenses consist of rent, utilities, insurance, internet
-> Variable expenses consist of food, hobbies, shopping, etc
The first thing that should jump off the page is whether or not your budget is balanced.
If your budget is balanced, congratulations. If it isn’t, you have your work cut out.
Since it’s difficult to significantly reduce your fixed expenses unless you move to a cheaper area or drastically decrease your quality of life, the easiest way to balance your budget is to reduce your variable expenses.
Here are three categories of variable expenses you can start reducing right now:
- Cigarettes & Alcohol are expensive habits that greatly impact your budget. The average smoker smokes half a pack of cigarettes a day which comes out to fifteen packs a month. If a pack costs $10, that’s $150/month or $1800/year. Add $50 of drinks a week and you’re spending $350/month ($4200/year) on very bad habits. Start by reducing your cigarette consumption, then quitting altogether. You can enjoy the occasional drink but really try to limit your spending in bars and nightclubs. Their markups are insane and ravage your bank account. Only spend what you budget for.
- Shopping is undoubtedly an American tradition. It’s also it’s a very dangerous addiction that can wreak havoc on your finances. The best short term remedy is to shop exclusively during sales season. The long term remedy is to buy only what you need. Shopping is a very stimulating activity that releases dopamine, the brain’s natural ‘get high’ compound. If you want to cure your shopping addiction, you must learn to reprogram your brain to get these dopamine rushes elsewhere, preferably in activities that don’t require spending money.
- Eating out is also a very popular pastime. After all, who doesn’t enjoy being served delicious food in wonderful settings? The problem is not eating out per se, it’s eating out too often. If you spend $10 five times a week at lunch time and $30 in the restaurant just once a week, that’s $320 a month spent on eating out, not counting what you eat at home, or $3840 a year. Start packing your own food to eat at lunch at least three times a week and limit your restaurant visits to once or twice a month.
Reducing your lifestyle is not an easy task. That is precisely why it’s not recommended to try and cut your variable expenses to zero. Rather, reduce them progressively until you spend what you can afford to. Don’t live beyond your means.
To make this process easier, ask yourself whether your current lifestyle is really making you happy. Does the pursuit of material goods provide you with the happiness you seek? Are you at all worried about how you will finance your retirement? Do you want to take control of your financial life?
Take the time to think these questions through. The answers you provide will be your motivation going forward.
3 – Pay Off Your Debts
Debt is a double edged sword. It can be your greatest weapon or the cause of your financial death.
First of all, you must understand that not all debt is bad debt. For example, getting a mortgage to buy a house or invest in real estate is considered good debt.
I want to talk about bad debt, namely credit card debt and debts from pay-day loan agencies. These are bad debts because they come with high interest rates and often lure you into the vicious cycles of over-indebtedness.
It’s vital you pay off these bad debts before you invest a single penny in the markets. What good is getting a 7-10% annual return when your credit card debt comes with 15% monthly interest?
Eliminate all of your bad debts as quickly as possible and never fall into this trap again.
The first months will be difficult but this will be one of the best financial decisions you’ll ever make. When you’ve paid off these debts, use the surplus money to save and invest.
4 – Define Your Objectives
People invest for many different reasons: to finance the purchase of a house, to pay for their child’s college tuition, to generate income for retirement or to reach financial independence.
You must determine how much you will invest, over what investment horizon and for what goal before you start investing. Otherwise, you’ll buy different products without knowing why and you’ll buy without knowing when you want to sell. The result will be a lack of coherence in your portfolio and, ultimately, lackluster results.
Once you’ve determined your objectives, ask yourself what is your risk tolerance. Put simply, investing is a trade off between “high-risk high-reward” and “low-risk low-reward”.
Generally, younger people are more willing to take on high risk to generate higher returns. Thus, they’ll favor smaller cap stocks and growing companies which provide potentially significant capital gains. Older investors will prefer safer investments such as blue-chip dividend aristocrats, bonds and index funds in order to build a retirement nest, generate income and safeguard their capital from the ravages of inflation.
Always remember that your strategy is determined by your objectives.
5 – Educate Yourself
Lastly, it’s very important that you cultivate a perpetual desire to learn.
From a purely technical point of view, learn about the basic terminology, the different financial products available for purchase and how to buy and sell them. Make sure you know the difference between stocks, bonds, options, warrants, index funds, mutual funds, market and limit orders, volume and liquidity. You can google these terms and find their definitions instantly.
Secondly, you must become a student of the world: read financial news, study economic history and analyze trends. This will allow you to understand how the markets work, how investor psychology affects them, and how to identify the secular growth trends that are defining our time.
Identifying the industries of tomorrow will allow you to invest in them rather than doing the lazy thing of investing in big names who may have started their structural – but not readily identifiable – decline. You want to make sure you’re investing in developing sectors which will generate returns on capital for decades to come, not park your money is stocks that are either going nowhere or falling.
The only way to do that is to analyze the world economy and to be in touch with the times.
Investing in stocks has never been easier but that does not mean that investing is easy.
Actually, it’s very hard if you’re financially unprepared and you don’t know what you’re doing.
Thus, it’s crucial you prepare yourself beforehand in order to maximize your chances of reaching your financial goals.
Do the five things presented in this article and you’ll be well equipped to start investing.
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.