There are many ways to go about investing and knowing which path to take can be a daunting process. You can narrow down the possibilities to a strategy that works for you by evaluating your current financial situation.
This should be done before you enter into your first trade. To be successful, an investor needs a clear picture of where they are going. Keep in mind this is not a one-time event. You should reevaluate your financial situation on an annual basis since it’s going to be changing. When you find yourself in a different financial situation, your investment strategies will change over time.
Where To Start
Establishing a starting point is the first step. You don’t have to be a financial wizard, but you need to be aware of your present situation before jumping in and buying stocks. Consider the following scenario.
An investor with a large personal debt that has an interest rate of 17% keeps putting money in the stock market, hoping to build wealth over time. That sounds reasonable, but most market returns are, going to be in the range of 5-10%. That means that someone in this situation is actually losing money.
We are going to recommend that you look for assets you can sell.
The money can be used to pay debts, back taxes, or seed investment capital. You’ll want to list all of your assets by liquidity, which means how easily they can be converted into cash. You’ll also want to consider how much cash you can raise by selling each item if you were to sell it. A house might have a lot more value than a television set, but you might sell the television set in 24 hours while you’d have to wait months to sell the house.
Dealing with Debts
Taking care of debts is one of the first things that a budding investor needs to do. While you might be anxious to get started with a large-scale investment plan if you have debts to take care of you might want to put it off. So, the first step in preparing your investment plan is to create a simple balance sheet. You don’t have to be an accountant, and you’re only doing this for yourself, but it needs to be honest and accurate.
You’re going to want to put together a listing of all of your assets and liabilities. When compiling assets, include everything of value that you could possibly sell. This could be a computer that you’re not using, a dusty TV in a room nobody goes into very often, or an old guitar.
Selling things, you don’t need can help you pay off debts faster and raise investment capital. You might object that you wouldn’t raise much money but imagine having an extra $500 to $1,000 to start off with.
When listing your liabilities, you’re going to want to know how much debt you have, what the interest rates are, and what your monthly payments are.
Monthly payments are less important than interest rates. Once you’ve listed all of your debts, you’ll want to develop a plan to pay them off in a reasonable amount of time. There are many calculators available online, and you can also read many books on how to pay off debt. The series of books by debt guru Dave Ramsey is highly recommended. Here is an example of a good debt calculator:
You can use this calculator to figure out how long it will take to pay off a debt for a given monthly payment. You can enter the interest rate, and the time frame you would like along with the monthly payment you’re willing to make. Start off with the current minimum payment in order to determine the time required to pay off the debt and work up from there.
In this example, we considered a $21,000 debt with a high 11% interest rate. Paying $450 a month would take five years to pay off the debt.
That isn’t a good situation to be in — do you want to saddle yourself with a $21,000 debt for five years?
When you have listed all of your debts, then you can prioritize them. In order to make the most progress in the shortest amount of time, it can be helpful to tackle the smallest debts first. This not only helps you get rid of your debt faster, but it will also have psychological benefits as you improve your financial situation.
If you have back taxes, you should make these a priority. The reason is that the government tacks on lots of fees and penalties, and if the tax debt is allowed to sit around, it can grow substantially in size. Get payment plans arranged to take care of these debts before they become unmanageable.
Take a look at your spending habits. Having material goods now isn’t important if you plan to become a successful investor. You will be able to buy that BMW or Mercedes you want later when you can really afford it. For now, your focus should be on being able to direct your financial resources into your investments
so that you can grow your wealth over time. Expensive toys, like a new car, can be a large financial drain. If you have car loans, consider getting out of the car and into a used car that is reliable but costs a lot less. From this point forward, don’t use debt to finance purchases. Keep a credit card on hand for emergencies, but don’t use it to buy things like books or groceries that should be paid for using cash. If you can’t pay for something with cash, it can wait.
Having an Emergency Fund
Life is never fair, and we are all going to encounter emergencies.
Recent studies have shown that most Americans don’t have enough cash on hand to pay a $500 bill. If you are in that situation, you need to rectify it before you jump in with a large-scale investment plan. Remember that paying off debt first is always the priority. Debt is a sink that sucks important financial resources down the drain that could be used for other purposes.
However, it’s important to start putting money away for an emergency fund to be prepared for the unexpected — and being able to pay for it without having to take on more debt. Or worse, getting into a situation where you can’t get credit but still need to find money to pay emergency bills.
Set aside a small amount of money that you can start depositing into a savings account that you won’t touch unless there is an emergency. Over time, the goal should be to have enough cash on hand to take care of emergency bills ranging up to $5,000 and to have funds on hand to cover times when you might be unemployed.
Consider Additional Sources of Income
If you have a large amount of debt or find yourself in a situation where coming up with a significant amount of money to invest is difficult, you should consider taking action to increase your income. There are many paths to consider. You can start by looking for a higher-paying job.
Alternatively, you can look into taking a second job, at least until you are in a better financial situation. Another approach that can be used is to either take on “gigs” or short-term contract work.
This can be done online or by doing some side work with companies like Uber. You can even look into starting your own online business to generate more income.
This doesn’t have to be a permanent situation, but you are going to want to get to a place where you are debt-free and can put $1,000 or more into the stock market every month.
Net Worth and Changes Over Time
When you’ve gathered everything together, you’ll want to determine your net worth. You are doing this for yourself, so don’t be embarrassed if it’s in a bad position right now. Simply add up the total current value of your assets and liabilities and subtract the total value of the liabilities from the total value of your assets. This is your net worth. If you can compare the value of each asset now to the value it had at the beginning of the year; you can also calculate the change in your net worth in percentage terms.
Are You Ready to Invest?
If you are debt-free or have a plan in place to take care of your debts and to build an emergency fund, you are ready to begin investing. The first rule of investing is to never invest more than you can afford to lose. If you go about your investment plan carefully, the chances of losing everything are slim to none. That said it’s a wise approach to invest as if that could really happen. So, you shouldn’t be investing next month’s house payment or your kid’s college funds in the hopes of gaining returns. After you have taken care of your debts and emergency fund, add up all of your basic living expenses, so you know how much you actually need per month. Anything left over above that is the amount of money you can invest for now.
Determining Your Financial Goals
Once you are in a position to invest something — even if you can only put in $100 a month now because you’re paying off large debts — it’s time to sit down and figure out your financial goals. There are several things to keep in mind:
Age: Generally speaking, the older you are, the more conservative you should be in your investment approach. The reason for this is simple. When things go badly, it takes time to recover and get back on the road to profitability. The older you are, the less time you have to grow your wealth in the future.
That means a market crash, or a bad investment has larger consequences than it would have if you had thirty years to recover. Financial advisors generally recommend that older investors put their money in safer investments, which means putting some money into bonds and safe investments like US Treasuries that preserve capital.
In the stock market, the older investor will seek out more stable companies that are larger, and while they may be growing, they have slow and steady growth with lower levels of risk. Of course, age can cut both ways.
Many people reach their fifties with little to no savings or investment. If that describes your situation, you’re going to want to invest more aggressively to seek rapid growth.
Younger people also want to invest more aggressively, as they have a time horizon that permits taking on more risk. But time horizon isn’t the only factor if you have no capital to protect; you definitely want to be more aggressive.
Learn The Right Investment Mindset By Reading Books
Mindset plays a large role in successful investing. My reading list contains many books on mindset.
A few weeks ago, I read the Rich Dad Poor Dad book and found it quite fascinating.
In Rich Dad Poor Dad, the author explores the steps to becoming financially independent and wealthy using autobiography and personal experience.
Narrative writing and framework characterize this book. Not technical insights or investment math, but anecdotes with nuggets of supposed wisdom, is the focus of this book.
The author compares his biological father’s (an intelligent, but financially inept father) lessons with the lessons his friend’s father teaches him (an uneducated, but brilliant and wealthy father).
In Kiyosaki’s life, this weaves through as he learns from the rich father and rejects the advice of the poor father (thereby eclipsing typical working-class attitudes).
However, some of the concepts in this book are questionable. Learn more about my thoughts about Rich Dad Poor Dad in my Rich Dad Poor Dad review.