5 Things to Do BEFORE You Start Investing
You’re young, you’re eager, you’re out in the workforce earning money, and you’re ready to jump into investing full force. Or maybe you’ve been working for a few years but have been too busy getting yourself established (and yes, having a bit of fun) to get serious about preparing for the future. Either way, you’ve done a little homework and believe you’re ready to pick an investment and put your money into it. Not so fast, says financial expert and best-selling author Eric Tyson, MBA. Before you make any wealth-building investments, you first need to get your financial house in order.
“Before you think about investing, you need to have a good financial foundation in place,” says Tyson, author of Investing in Your 20s & 30s For Dummies, Second Edition(Wiley, 2017, $19.99). “There’s a natural order to managing your money and setting yourself up for a secure future. If you don’t follow it, you can set yourself up for big headaches down the road—or at least fail to maximize your nest egg.”
Tyson explains that most young people today have debts from lingering college loans or credit cards, and have little savings for unexpected expenses. Even though investing sounds like an exciting solution to financial wellness, you need to take care of a few other issues first.
First things first: Set your financial goals.
Do you have established financial goals that you’re working toward? If not—and frankly, too many young people simply don’t think this way—Tyson advises you to figure out your financial goals before you begin investing. Otherwise, you won’t know how much to save or how much risk you need to take or are comfortable taking. Plus, there may be several goals you want to save for and that will affect your investing strategy.
“When I was in my 20s, I put some money away toward retirement, but my bigger priority was to save money so I could hit the eject button from my management consulting job and start my own business,” says Tyson. “I kept the money I saved for the start-up of my small business, which was a shorter-term goal, safely invested in a money market fund that had a decent yield but didn’t fluctuate in value.
“By contrast, my retirement was a longer-term goal, so I invested the bulk of my retirement money in stock funds,” he adds. “If these funds fluctuated and declined in value, that was okay in the short-term, because I wouldn’t be tapping that money.”
Pay off any high-cost debt.
This might be a bit of a no-brainer, but paying off any consumer debt you have, such as on a credit card or auto loan, should be your first priority. Consumer debts are charged a high interest rate (many 18 percent or more per year), which keeps the debt growing and can cause your debt to quickly spiral out of control. Tyson recommends reducing and eventually eliminating this debt—otherwise, it can be a major obstacle to investing and achieving your future goals.
“Paying down debts isn’t nearly as exciting as investing, but it can make your future investment decisions less difficult,” explains Tyson. “Rather than spending your time investigating specific investments, paying off your debts with money you’ve saved may indeed be your best investment.”
Build an emergency reserve.
No one knows for sure what life will bring, so having a reserve of cash on hand just makes good financial sense. Tyson generally recommends having at least three to six months’ worth of living expenses as an emergency reserve. Invest this money in a money market fund. Without a financial safety net in place, later on you may be forced to sell an investment at a lower price.
“If you have generous parents or dear relatives, you can certainly consider using them as your emergency reserve,” says Tyson. “Just be sure you ask them in advance how they feel about that before you count on receiving funding from them. If you don’t have a financially flush family member, the onus is on you to establish a reserve.”
Assess paying student loans.
Many millennials are now starting out with student loan debt. If you’re one of them, you’re probably questioning whether you should focus on paying down that debt first or investing your extra money. Tyson says that your choice will likely depend on the interest rate on this debt (after factoring in any tax breaks) and how that compares with the expected return from investing.
The question you need to consider is this: Can you reasonably expect to earn an average annual rate of return from your investments of more than the effective interest rate on your student loan?
In addition, there are some other factors you should consider when deciding whether you should pay down student loans faster. Maybe paying off your student loans faster has no tax benefit or drains your emergency reserves. Or maybe you’re game to invest in growth-oriented, volatile investments like stocks and real estate. These are good reasons not to pay off your student loans any quicker than necessary.
Now, find a way to commit to saving 10 percent of your salary.
To accomplish your financial goals, you need to continually be saving money. Tyson recommends saving 10 percent of your annual income each year for the rest of your working life. Admittedly, this is no small task. Some people may be able to find a higher paying job or even get a second job, but for most, this 10 percent will have to come from spending cuts.
“To reduce spending, sit down and figure out where your money goes,” says Tyson. “Examine your bill-paying records and credit card statements. Tally up how much you spend dining out, operating your car, paying taxes, and everything else. Then prioritize and determine where you can cut back on spending to boost your saving rate. This may require a lifestyle shift that may or may not be easy at first—but once you get started, it will quickly become your new normal and you will stop feeling deprived.”
“Even if you’ve got a great job and a bright future on the horizon, it’s unwise to dive into investing without first carefully considering your long-term goals and getting your personal finances in order,” concludes Tyson. “When you’re young, you’ve still got plenty of time to invest, so don’t get ahead of yourself. Focus on getting your finances in order, and in the years to come, you’ll reap the benefits of the strong foundation you’ve built.”