With record numbers of people entering the stock market over the last year, trading and investing have become part of popular culture. The growing ubiquity of stock market investing can sometimes make it seem too easy, though.
In this article, we’ll discuss six key questions investors must ask themselves to be successful as they build a portfolio of stocks and other investments.
1. What Does Your Personal Financial Situation Look Like?
There’s personal finance and there’s investing. They overlap but it’s most useful to consider them as distinct entities.
Let’s label personal finance as everything in your life money-related that comes before investing. Concerns such as budgeting, saving, spending habits, and managing debt. As the U.S. Securities and Exchange Commission (SEC) advises, you should consider your entire personal financial landscape as you consider when and how you’ll enter the stock market.
Before investing, ensure that you’re operating from a position of financial strength. We can boil this down to having a sense of “cash security.”
First, build an emergency fund equal to three months to one year of expenses. Make sure you feel comfortable if you lose your job or find yourself in a situation with reduced income.
Then work on eliminating high-interest debt, such as credit cards and personal loans. Generally speaking, ensure you’re not paying out more in interest than you’re earning on your prospective or current investments.
It’s important to assess your debt and cash situations beforehand. The last thing you want is to need to cash in your investments to solve a money issue. This stunts the wealth-building process, as time—as much, if not more than anything—fuels the growth of your nest egg.
Once you have your personal finances under control, it’s time to focus on an investment strategy that works well for your income, routine cash flow, and near- to long-term goals and dreams.
2. When Do I Need This Money?
Specific financial goals that are driving your investment decisions may help you determine your investment horizon. There are different strategies and investment products to explore, depending on whether you’re investing for the near term or are in it for the long haul.
Say you’re in your 30s and looking to build a retirement fund. That means you’re likely looking at a 30-year investment time frame. If so, you’re perhaps better off following a buy-and-hold policy for your equity investments.
For example, as of June 2021, the average ten-year return on the S&P 500 was 12.64%. Assuming the same return for the next 30 years, a one-time investment of $1,000 in the S&P 500 would grow to $35,545 by the end of that period.
Conventional investing guidance says that if you’re young with a long runway before retirement, you should be more aggressive with your investment choices. While this isn’t necessarily bad advice, there’s no one size fits all.
Some investors focus on return, which is how much income your investments generate.
We’ll break this approach down into its simplest terms.
If you have $1 million invested, yielding 5%, you can reasonably count on somewhere around $50,000 in annual investment income. In a perfect world, you don’t touch your principal. Instead, you collect this investment income, usually from dividends and interest, and live off it.
This method can work with stocks, mutual funds, and bonds. It tends to be most lucrative if you own a basket of high-quality stocks that pay attractive and consistently growing dividends.
But if you’re looking to use the return on investments to buy a car in five years, for example, you probably want to take on less risk and consider savings products such as short-term certificates of deposit or money market funds.
3. How Much Risk Can You Stomach?
This is one of the most important questions you need to ask yourself before you invest. A simple way to figure that out is to consider how much money you are comfortable losing if your investment tanks.
The allure of spectacular returns in stocks or from other assets such as cryptocurrencies can be strong, but their wild swings in prices can spook even the most devoted investors. Starting in 2020, there has been an influx of retail investors entering the stock markets, especially with stock-trading apps making it so easy to buy and sell shares.
Many ordinary investors have been drawn to “meme stocks,” which experience a jump in volume not because of the company’s fundamentals, but rather because of hype on social media and online forums like Reddit. These stocks often become overvalued, seeing drastic price increases in a short amount of time, but they can also lose value just as fast. Avoiding completely or experimenting cautiously with such volatile investments can be a sign of your risk tolerance.
4. Does This Help Me Hedge Other Investments?
Stocks tend to present the most risk but offer the greatest potential for high returns. On the other end of the spectrum, bonds usually generate lower returns on average, but come with reduced risk.
Again, how you’ll split your portfolio among stocks, bonds, and other assets, such as mutual funds and cash, depends on your cash situation, time horizon, risk tolerance, and unique psychological reactions to personal finance and investing.
Second, evaluate how you’ll diversify your investments using different asset classes.
For example, if you’re investing in stocks, will you put all of your money in high-flying technology stocks? Or will you spread your exposure around by also buying and holding more defensive stocks, such as companies with a long track record of paying dividends?
Deciding on these factors will help you determine your investing style. There’s no textbook category you’ll fall into. It comes down to experimenting with your comfort level across and within assets.
5. What Are the Costs Involved in This Investment?
If you’re buying an investment product like stock or even a mutual fund, you are paying a certain value for it. But there are other costs that you need to evaluate as well. Consider the following before making your investment decision:
Am I Overpaying for This Investment?
Valuations, especially for stocks, can be tricky. How do you evaluate if you are paying too much for a stock or getting it at a discount? If the stock is already overvalued, it may not generate big returns—and it could undergo a price correction that could diminish your investment. Do your homework about the financial health of the company, the outlook of the sector, and how its peers are faring to understand if the shares are overpriced or not.
If you’re convinced of the investment but unsure of the price, consider dollar-cost averaging by making smaller steady, recurring investments in it, instead of one lump-sum investment.
Fees and Expenses
Be aware of transaction costs that come with trading in stocks. Typically, there’s a charge for each transaction and if you’re trading frequently, those costs can add up. There are discount brokerages that have eliminated transaction fees, but watch out for other hidden charges.
Mutual funds also charge a plethora of fees and expenses, some obvious and some less so. For example, if you invested $100 in a mutual fund with a 4% front-end sales charge, or “load,” only $96 of your money actually would get invested.
If you work with a professional investment advisor, also consider the fees or commission they charge you for managing your money.
6. How Much Tax Do I Need to Pay?
A successful investment doesn’t result only from putting money into a product and watching it grow. It also involves taking the money out and using it. But capital gains taxes can take a bite out of the increased value of your investment.
When you’re considering selling your investments, remember that profits from ones held for less than one year are taxed as ordinary income, whereas anything held longer is taxed as a long-term capital gain at a much lower rate.
Another taxation strategy to be aware of when investing is called “tax loss harvesting.” It’s usually possible to offset your capital gains with capital losses you’ve incurred during that same tax year, or carried over from a prior tax return. This approach can counter capital gains taxes and may lower your tax bill.
The Bottom Line
Given the recent elevated interest in the stock market we have seen—intensified by the pandemic—there has never been more investment advice on the internet. While this is useful, some of it takes a one-size-fits-all approach.
To build your ideal investment portfolio, devise a plan that best suits your unique personal financial situation. From there, tweak the plan to jibe with your goals and an investing style you’re comfortable with. If purchasing stocks or any other asset triggers worry or anxiety, you should reconsider what you’re doing.
In the midst of the outsized attention we’re paying to investing these days, there have never been more options for the individual investor. Fintech platforms and internet research put resources to make decisions at your fingertips. It also helps to have access to a financial advisor you feel comfortable with who can assess your overall money landscape and help you devise a comprehensive investment plan that suits your personality and goals.