Here are some basic rules that anyone who is considering investing should think about.
1) Only start investing with extra money and have no debts
This simple rule, if adhered to would save many people thousands of dollars. Many people think about starting a savings account that pays 2% per year on their balance. All the while, they are carrying credit card debt that cost them 20% per annum on their balances. Not to mention the fact that you still pay taxes on whatever you end up making in your savings account (if it’s not in a tax deferred or tax free account) and pay any interest on your credit card account with after-tax dollars. The problem is that the 2% that you earn is 100% taxable at your tax rate. For example, let’s assume that you have $10,000 sitting in a savings account earning 2% per year. After one year, you will have made $200 (at a 2% savings rate) but if you’re in the 40% tax bracket, you would lose $80 to taxes. That hurts…bad. So not only are you making only a little bit of money, but taxes eat up a good portion of whatever you do make.
What if you hold credit card balances and pay interest on the balance. Here is how much you are really paying for them. Let’s assume that you hold an average balance of $5,000 on your credit card and were charged 20% annually. After one year, you would have paid $1,000 in interest (5 times what you would have made in interest in the 2% savings account). But wait, don’t forget that your interest payments are done with after-tax income. So let’s assume once again that you are in the 40% tax bracket, you would actually need to make just over $1,650 to pay for the interest on your credit cards!
You can even go further and pay off your mortgage before investing. Personally, that’s exactly what I did before investing in the markets. I was paying 4.5% interest on my mortgage… guaranteed!! I don’t know about you, but I would be extremely happy with any stock that earns 4.5% a year, guaranteed and tax-free!! So my advice to anyone would be to pay off any debt before investing any money in the stock market. Some would think this is too conservative, but I think it’s risk-proof.
2) Have an emergency reserve fund
Once you have paid off all of your debts, you should think about having an emergency fund. Most people do not do this, but it is essential to preventing you from getting into any debt to pay for a broken down car, leaking roof, or if any unexpected expense. Typically, you should have two to three months salary saved and easily accessible. You can increase this if you worry about your job security or foresee a poor economy ahead – like now. This ensures that if an emergent expense comes up, you do not have to rely on your credit cards (ie. debt).
3) Know your goals
Ask yourself the following:
What you are investing for??
Are you investing for retirement? If you are, you should be thinking long-term investing. However, I don’t mean passive investing – leaving it in your accounts and not thinking about it. You should always review your investments and when the market gets sketchy, you should any or all of your investments, if warranted. However, do not make the mistake of selling at the low and buying at the high. As I have discussed in my previous post:
“Be fearful when others are greedy and greedy when others are fearful”
If this statement is kept in mind, it will make you more money than you will know what to do with. And remember, this applies to real estate as well as stocks. During the US housing bubble or 1999 tech Bubble, people were making money and getting greedy. This lead to massive speculation in stocks and real estate.
How much money do I plan to save?? Are you planning on using this money soon??
Are you going back to College or University, buy a house or car? If so, you may want to hold off investing in the market since you may be better off using the money for your purchases. All of these should affect your investing goals since you may need this money sooner than you think. All of these questions should get you thinking about your investments, debt, and disposable income.
4) Start early and small
It is no surprise that the earlier you start investing, the faster you will accumulate your fortune. Ensuring your investments benefit from compound interest earlier in life will help that you seek your investment goals sooner. Here is a graph showing the growth of one dollar over time at different compounding interest rates.
I think this graph shows a valuable mathematical lesson: the benefits of compounding interest. Note how it would take almost a a millennia to earn $10,000 dollars from a single dollar when compounding at 1% but and yet only 66 years while compounding at 15%. This graph is often referred to as a hockey stick graph due to the abrupt curve in the graph, which is similar to a hockey stick.
Recently, I wrote an article describing the benefits of the Dividend Reinvestment Plan and how it can benefit you. The power of compounding interest is one of the benefits to investing in stocks that have provided steady dividend growth.
If you plan on starting to invest in stocks or bonds, I would recommend starting small to see if it is right for you. As a small investor, you are at a disadvantage when trading stocks. Everyone is out to get your money. The sooner you know this, the more money you will make in the market.
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