4 Things You Must Do Before You Invest One Dollar in the Market
We’re in the eighth year of a raging bull market, and it’s tempting to dive into the investment markets. Since 2009, the S&P 500’s returns were positive every year. The top two years garnered 32.15 percent in 2013 and 25.94 percent in 2009. At the bottom of the pack, even the worst two years eked out returns of 1.36 percent in 2015 and 2.10 percent in 2011, both greater gains than you’ll get from a savings account.
And if you go all the way back to 1928, you’ll find that the S&P 500 rewarded investors with a juicy annualized return of 9.52 percent.
Yet recent performance and long-term returns camouflage the down years of the investment markets. In 2008, the S&P 500 tanked 36.55 percent, and the first three years of this decade were painful, with losses of 9.03 percent, 11.85 percent, and 21.97 percent in 2000, 2001, and 2002, respectively.
As reflected by the up and down years of the stock market, you need a strong stomach and some investment knowledge before diving into the markets. Here’s what you need to know about your personal finances before you jump into the market.
Step 1: Pay Off High-Interest Debt
Debt levels are creeping up to 2008 levels according to a recent CNN article. Last year household debt exploded by $460 billion. And if you’re in an “average” household, you’ve got $16,048 in credit card debt.
Here’s why you need to get that debt paid off before investing.
If you’re paying credit card interest of 16 percent then it’s essential to earn a return greater than 16 percent to justify investing in the stock market before paying off debt. For example, if you pay 16 percent interest or $2,568 on your credit card debt and earn 9 percent on the stock market investment, then you’re losing 7 percent or $1,124 by not paying off the debt.
In other words, paying off high-interest debt is a certain return, equal to the interest rate charged on the debt. And unless you get really lucky in the market, you’re unlikely to top the return you’ll get from paying off your credit card debt.
Step 2: Cover Your “What Ifs”
Imagine getting into a fender bender and your insurance deductible is $500. Or worse yet, you get laid off and don’t find a new job for 3 or 4 months. Do you have a few thousand bucks to cover these unexpected expenses? If not, you’re not alone. Forty-seven percent of Americans claim they can’t afford an emergency expense of $400, according to a recent Federal Reserve.gov survey.
If you can’t afford a financial emergency then, you’ll need to borrow or sell something to get the cash. Or, if the money that you need for an emergency is invested in a stock market exchange traded fund (ETF) that you must sell, you’re at risk of selling at a loss. That’s why you need to save several months of living expenses before investing in the stock market. Put the “what if” savings in an accessible money market or savings account, so the money’s available when you need it.
Step 3: Learn Investing Basics
Once you’ve paid off your consumer debt and built up savings, it’s tempting to dive into the investment markets.
But if you don’t understand what you’re investing in, there’s a good chance you’ll end up losing money by buying high and selling low. By investing with your emotions, instead of your head, you’re apt to get excited when the markets are peaking and dive in at the top of a bull market. Then as the inevitable decline occurs, it’s common for fear of loss to take over causing you to sell at a market trough.
So, before buying your first stock or bond fund, spend a few hours educating yourself about the investment markets, trends, and individual financial assets. Study investment diversification principals and learn about how holding stock and bond mutual funds will lead to steadier investment returns. Finally, read Warren Buffett’s advice and invest in low-fee index funds.
Step 4: Take Care of Your Family
Finally, before investing, get your own financial house in order.
If you have kids or someone depending on your income, then consider buying affordable term life insurance. Also, consider purchasing disability insurance, especially if you’re in a physically demanding job. That way, if something happens to you, your loved ones are taken care of.
These are the four steps you must take before you start investing… but there’s one exception. If your employer matches your 401(k) contributions, then you should contribute enough to your workplace retirement account to get the match — even if you haven’t yet completed these four steps. You can’t afford to turn your nose up at free money!
Barbara A. Friedberg is a former portfolio manager and author of How to Get Rich: Without Winning the Lottery. Her writing appears on various websites including Robo-Advisor Pros.com and Barbara Friedberg Personal Finance.