Whether you are deciding to do it yourself or hire a financial planner to get it done for you, investing can be intimidating. But the reality is unless you plan on winning the lottery your retirement plan will more than likely include some sort of investment strategy. This could be anything from real estate, businesses, stocks, or bonds etc.
There are two pretty significant errors that people make today when debating whether or not they should start investing. One is the fact that they are financially ready to invest but delay the process, resulting in loss of potential earnings. Secondly, people may start investing when in fact they have skipped crucial steps along the process that again may cost them potential earnings.
I’m going to go over 3 key factors you need to take into account before you start investing. If you’ve got all three of these nailed down, great! You’re probably ready to start building a portfolio and working your way towards financial freedom. If you’ve overlooked or are unaware of some of these things, maybe it’s time to take a step back, tackle these elements and then dive into the stock market.
3 Key factors in determining if you’re ready to invest
Do I have an “uh-oh” fund saved?
Unless you’re trying to become a trader, the money you place in an investment account whether it be a 401K or an RRSP should be in there for the long-haul. The last thing you want to be doing as an investor is having to sell your positions and withdraw funds to pay for emergency expenses.
The reasons for this are fairly self-explanatory. First off, money withdrawn from your RRSP or 401k is subject to tax. If you need $2000, the IRS and the CRA are going to immediately hold back 10% of that, so you will need to take $2200 to cover your expense. The withholding tax in Canada actually escalates to a greater amount the more you pull out. And unfortunately, depending on your financial situation you may be paying more to the tax man when it comes time to file.
Secondly, the money you withdraw from your investment accounts simply isn’t earning anything. You’ve taken away a percentage of your portfolio that was once accruing income.
The best strategy when you are starting to invest is to only invest money that you don’t plan to touch. The easiest way to achieve this goal is to simply have an emergency fund for when situations arise where you need cash at hand.
In Canada, we have the benefit of the Tax-Free Savings Account. Funds in the TFSA can become liquid and be pulled out with no penalty, so the TFSA can become somewhat of a hybrid emergency fund and investment account. But, be aware that rule number 2 explained above still applies.
Are my debts costing me more than my investments are earning?
7% is a number you’ve probably heard before when talking about the stock market. This is the average return you can expect to see with a diversified portfolio. If you currently have any debt that exceeds 7% in interest, it probably makes sense to tackle this debt prior to investing.
A lot of credit card interest can feel like it’s hidden. What I mean by this is a lot of people aren’t actually aware of the interest they are paying on their credit card because it is just added to the bill and you get a total amount for the month.
The mental effect of earning money on investments may overshadow the interest you are paying on your credit cards or other high-interest debts as this is actual cash you have earned. It feels good. The reality of it is, if you were to take the capital you have in your investments and dump it on your high-interest loans, it would far surpass in savings what you could ever expect to earn in the stock market barring some extreme short term variance.
Get rid of your high interest debts prior to investing. Mortgages and most vehicle loans are probably ok unless you have got yourself into a situation of bad credit.
Do I have a plan?
Ok, so you’ve got your emergency fund saved up and you’ve paid off all of your “bad” debt. You’re ready to invest! Let’s throw some money on Questrade and start buying stocks right?! Wrong.
I would argue that this is by far the most important phase you need to go through prior to starting out, and here are some questions you should be asking yourself before beginning.
1) Do I need an advisor, or would I rather invest by myself?
2) What are my financial goals 5, 10, 15, or even 20 years down the road?
3) How much risk am I willing to take responsibility for in my current situation?
4) What am I going to invest in?
5) How much can I set aside each month to place into a TFSA, RRSP, or 401k?
Just as an NFL coach doesn’t go into Sunday’s game with absolutely no game plan, you need to have a concrete investment plan before you place a dime of your money in the stock market. Is your goal to invest in small-cap growth stocks? Blue chip dividends? What industries are you looking to target? How will you go about analyzing the stocks that you feel will provide growth? The Balance has a great article about creating an investment plan that works for you. I highly suggest you check it out.
Summing It All Up
We all want to start making our money work for us. The fact is, the stock market is not a guaranteed avenue to financial success. You need to know what you’re doing, and be financially prepared. Only once both of these conditions are met are you ready to start investing.
If you are financially ready to begin an investment portfolio, check out this article on how to buy stocks. It is my article explaining how to buy stocks in Canada, but is relevant worldwide and will really help you tackle the “know what you are doing” part. Always keep in mind that the more you learn about the markets and the industries you intend to invest in, the higher your chance of success.