A lot of people have asked me to write a post about how to invest in the stock market. I love the fact that young people are excited about investing and are trying to become the CFOs of their personal economies, BUT there are a few things one has to do before investing. So before you set up your brokerage account, or buy Apple stock (as a lot of young people do), make sure you’re not overlooking these essential rules:
- Pay off high interest debt: Any debt that is high-priced, which is credit-card debt for most people, should absolutely be paid off first. Most credit cards have interest rates between 16-18% and if you are stashing money in your 0.5% interest (or in some cases 0%) savings account each month, rather than paying off your credit card bills, you’re committing financial suicide! This is the most important step!
- Emergency Fund: An emergency fund is a “safety blanket” or a cash cushion. This is necessary because life happens! Your car may break down, or you might need to have a root canal surgery; you might even need to be rushed to the hospital. Guess what? A ride in an ambulance costs about $240 (in Ontario, Canada). If you do not have money saved, you would have to resort to using a credit card, which comes at a high-price. This goes against the basic rule to “Avoid credit-card debt like the plague.”
As a general guideline, your emergency fund should be in an easily accessible savings account and should cover your living expenses for 3-6 months if you have no dependents. If you are a breadwinner or work in a volatile industry, this should be about 6-12 months of living expenses.
- Set Goals: You should set short-term (ST) and long-term (LT) financial goals. This will determine what kind of financial instruments you invest in and the kind of financial decisions you make. If you need the money in the next year (for example for tuition, or a vacation), this should be in cash. If you need the money in 5 years (for example, for post-graduate tuition, down payment for a house etc.) this money should be in safe income-producing investments like bonds, treasuries, and so on. These types of investments do not provide great returns. However, they give you the guarantee that your money will be there when you need it (in other words, you can have a good night’s rest!)
Any money that you do not need in 5 years can be put in the stock market. This is because a 5 year time period gives your money the time to ride through the market’s ups and downs. You have to know what you need the money for to determine what you invest in. If you don’t plan, you might find yourself selling off stock at the worst possible time (and incurring a huge loss in some cases) to meet your cash demands.
- Have A Concrete Savings Plan: You must have a concrete budget that works for you and a concrete savings plan! You should be able to predict how much income you make every year, and your basic expenses in order to predict how much you would be able to save and invest every month. One easy rule to follow is the 70-20-10 rule, with 70% of your income going towards living expenses, 20% towards short term and long term savings (retirement, emergency fund, and planned spending), and 10% towards debt repayment (if you have no debt, this can go towards your savings as well). To help you get started learn how to build a budget that works.
- Educate Yourself: Learn more about how capital markets work and the different financial instruments out there. Don’t just go to your bank and talk to your financial adviser. They don’t always have your best interest at heart. The first time I went to a bank, the financial adviser tried to make me invest in mutual funds that had a 2% expense ratio. I later found out that there were index funds, exchange traded funds and even mutual funds that provides the same (or higher returns) at lower cost. By educating myself and essentially becoming my own financial adviser, I was able to construct a well-diversified portfolio with great returns, and relatively low costs (the highest management expense ratio I pay for my investments is 0.5%).
With the thousands of financial instruments out there, you just have to figure out what is right for you. This is based on the amount of risk you are willing to take, how much money you have to invest, and how much time and interest you have for investing, amongst other things.
Read books, websites, blogs, and talk to people (who know what they are doing) to learn more. Most importantly, subscribe to this website to get new posts in your email! Also, feel free to email me at firstname.lastname@example.org or leave a comment on any of the posts.
Once you have all these things in place. You are ready to start investing! So how can you start investing? Watch out for subsequent posts!
Are you overlooking any rule?