With record numbers of people entering the stock market over the last year, trading and investing have become part of popular culture. Because stock market investing seems to be everywhere, you might think it's easy to do. To be good at it, there are some vital things you need to know.
Learn about the six key questions you should know the answers to if you want to build a good portfolio of stocks and other investments.
1. What Do My Personal Finances Look Like?
There’s personal finance and there’s investing. They do overlap, but it’s most useful to think about them as distinct factors.
Think of personal finance as all the things in your life that have to do with money besides investing. Concerns such as your budget, saving, spending habits, and managing debt could fall under personal finance. You should look at your entire personal finance picture as you decide when and how you’ll enter the stock market.
Before you invest your money, ensure that you’re coming from a place of financial strength. This means having a sense of “cash security.”
To get started, build an emergency fund equal to three months to one year of expenses. Make sure you can survive if you lose your job or find yourself in a situation with a lower income.
Next, work on getting rid of high-interest debt such as credit cards and personal loans. Make sure you’re not paying out more in interest than you’re earning on investments you have now or you're thinking about getting in the future.
It’s vital to assess your debts and cash flow ahead of time. The last thing you want is to need to cash in your investments to solve a money issue. This stunts the process of building your wealth. Time fuels the growth of your nest egg more than just about any other factor.
Once you have your money 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?
The money goals that are driving your investing choices may help you decide your investment horizon. There are different investment strategies 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 investing time frame. If so, you may be better off using a buy-and-hold policy for your equity investments.
For instance, as of August 2021, the average 10-year return on the S&P 500 was 13.97%. Assuming the same return for the next 30 years, a one-time investment of $1,000 in the S&P 500 would grow to $50,549.45 by the end of that time.
Conventional investing guidance says that if you’re young with a long runway before you retire, you should be more aggressive with your investment choices. While this isn’t bad advice, there’s no one choice that fits all people.
Some investors focus on return, which is how much income your investments bring you.
This approach should be looked under the simplest terms.
If you have $1 million invested, and it yields 5%, you can count on an amount of around $50,000 in annual investment income. In a perfect world, you don’t touch your principal. Instead, you collect this income, usually from dividends and interest, and live off it.
This method can work with stocks, mutual funds, and bonds. It tends to be a better deal if you own a basket of high-quality stocks that pay good looking and growing dividends.
If you’re looking to use the return on investments to buy a car in five years, for instance, you may want to take on less risk and look at savings products such as short-term CDs or money market funds.
3. How Much Risk Can You Stomach?
This is one of the most vital questions you need to ask yourself before you invest. A simple way to figure that out is to think about how much money you are ok with losing if your investment tanks.
The allure of great 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 getting into the stock markets, especially with stock-trading apps making it so easy to buy and sell shares.
Many investors have been drawn to “meme stocks,” which will get a jump in volume not because of the company’s bottom line, 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 them 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 get lower returns on average but come with reduced risk.
How you opt to fill your portfolio with stocks, bonds, cash, and other investments depends on your needs such as having access to quick cash, time horizon, risk tolerance, and unique circumstances. Evaluate how you’ll diversify your investments using asset classes.
If you’re buying 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 decide the style you want to use when you invest. There’s no textbook category you’ll fall into. It comes down to finding 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 look at as well. Before choosing how you invest, consider the following.
Am I Paying Too Much for This?
Valuations, especially for stocks, can be tricky. How do you figure out if you are paying too much for a stock or getting it at a discount? If the stock is already valued too high, it may not bring big returns. Also, it could undergo a price correction that could bring down your investment. Do your homework about the financial health of the company, the outlook of the sector, and how its peers are faring to decide if the shares are priced too high.
If you know you want to invest in a stock but are unsure of the price, consider dollar-cost averaging by making smaller and steady investments in it, instead of one lump-sum payment.
Fees and Expenses
Be aware of the costs that come with trading in stocks. Often, there’s a charge for each transaction. If you’re trading a lot, those costs can add up. There are discount brokerages that have done away with transaction fees but watch out for other hidden charges.
Mutual funds also charge a lot of fees and expenses, some of which are clear and some less so. For instance, if you put $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 an investment adviser, also take into account the fees or commission they charge you for helping you invest your money.
6. How Much Tax Do I Need to Pay?
A good 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 thinking about selling your investments, remember that profits from ones held for less than one year are taxed as ordinary income. Profits received after a year or more are taxed as a long-term capital gain at a much lower rate.
Another tax strategy to be aware of when you invest is called “tax loss harvesting.” It’s often possible to offset your capital gains with capital losses you’ve had 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 high interest in the stock market, we have seen—made more intense 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 portfolio, devise a plan that best suits your unique financial situation. From there, tweak the plan to jibe with your goals and an investing style you have comfort with. If buying stocks or any other asset triggers worry or anxiety, you should take time to think about what you’re doing and where your money is going.
In the midst of the extra attention we’re paying to investing these days, there have never been more options for the individual investor. Fintech platforms and internet research gives you the resources you need to make your investment choices. It also helps to have access to a financial adviser trust who can assess your overall money picture and help you devise a full investment plan that suits your life and goals.