Most people start investing without having the proper foundation in place. There are five tasks that should be accomplished before getting involved with investing.
Perhaps by the title you were thinking that I might be cautioning against investing at this particular time. For some that is exactly what I am saying, but it has nothing to do with market prognostication. After all, with proper dividend investing, timing is of little significance, but that is fodder for a different article.
I occasionally participate in the Quora forums, where people ask and answer questions. Within the dividend realm there are numerous questions that can only make one shake their head in despair. For instance:
And the amusing:
When I think back to a time when I was much younger I can imagine myself asking these very questions. With the current success of the stock market (this is written in January 2020, so keep that in mind) it is natural to think that just throwing money in that direction will result in financial success.
Stepping back a couple of decades this could have been the situation. The craziness of that time could be represented by TheGlobe.com, a social networking site. It went public in 1998 and the shares jumped over 600% on its first day of trading.
Perhaps we know what happened from there - the price fell to ten cents, the company went out of business, and today their website cannot be reached, thus the reason why the link to it above goes to Wikipedia. Many people made money during that time, and many people lost money.
The investing mindset is a key component to prudent investing. Throwing one’s money into the air with the expectation of success is something that simply does not work. Building a proper foundation before one begins to invest not only sets a proper framework from which to build success, but also establishes the proper mindset that keeps one from delving into penny stocks and get rich quick schemes.
There are five tasks that should be performed before beginning to consider the selection of companies for their portfolio. While these items may take quite a bit of time to perform, they will act as preparation for the investment of one’s hard earned money.
1. Get rid of all credit card debt
There is good debt and there is bad debt. Good debt goes toward a specific objective that one can use to better their life. Education can put one into debt, but the degree that the education offers will allow one to get a better job. A car may put one in debt but it is probably necessary to get one to work. A house will almost certainly place one in debt, but the structure becomes equity.
Bad debt results from not being able to afford what has been purchased. I use my credit card on a regular basis because I get cash back, but pay the card in full when the bill is due. If I could not do this then that would indicate that I am spending too much (or not earning enough). Not being able to pay off a credit card is financially unsound and acts as a negative investment.
2. Max out any matching funds that your employer offers
Even better than sliced bread is the opportunity to invest in an employer’s 401(k) or equivalent. The money is taken from the paycheck before taxes so one’s overall taxes are lessened. These funds are eventually taxed at a time when the tax rate is almost certainly probably lower.
If the employer offers a match of any money invested then that percentage should be maxed out. Some employers offer up to 7.5% matching of funds. Whatever the employer is willing to offer, that is what is referred to as “free money” and actually an untaxed (at the moment) increase in salary.
3. Open a savings account and add to it until you have three months of money
I seldom suggest placing money into a savings account but this is an exception. The interest rates on savings accounts are such that one actually loses money over time due to inflation. A savings account, however, has the guarantee of retaining the amount entered. The same could be said of a money market account or CD (although one needs to make sure that they will not need the money before the CD matures, a mistake I made long ago). Any instrument that insures the amount will suffice.
The reason for doing this is insurance against the peril of losing one’s job. In my working life I was laid off more times than my wife had jobs – just the hazards of being a programmer – which is perhaps why I see this as imperative. The last thing you want is to have to pull your money from working investments at a time not of your choosing. This reserve will give you three months of confidence that the rent will get paid, you will have food to eat, and will enjoy heat in the apartment or house.
4. Open a Roth IRA
This also falls into the category of “free money.” A Roth IRA allows one to invest for retirement, and when the time comes there are no taxes on the capital gains. I wish that this had been available when I was younger, but when it was offered I maxed it out.
One can place up to $6,000 a year ($7,000 a year if 50 or older) into the Roth IRA. For example, if over 20 years one invests $120,000 into the Roth and the investment grows to $300,000, that $300,000 can be pulled out at the age of 59½ without having to pay taxes on the $170,000 in capital gains. Like I said, free money.
The ability to withdraw the money tax-free is not only great in itself, but can also be used as a means of minimizing taxes when combined with extracting taxable monies from one’s account. It is an all-around win.
5. Maintain a budget
It is easy to be surprised with things like car repairs, which (of course) always happen at the worst times. It is much better to know that at some point one’s car will need to get repaired, so if money has already been set aside for this eventuality then the hit is not as severe.
For my budget I use a simple Excel spreadsheet and have categories like Electric, Car, Cable, etc., as well as things I am saving for (vacations, music festivals, etc.). Each month I add money to each month’s row and remove what was spent that month in that row. I know what is coming in and what is going out so that I don’t get in trouble. If you want to use the spreadsheet I am using and modify it to your own needs then I have made available an example spreadsheet, but anything that works can be used (I started long ago just using graph paper).
At this point one can think about investing.
For some this may sound like a lot of unnecessary steps, especially when one sees a booming market and wants to jump in and make money. But there are two things these steps do.
The first is that they establish a foundation of financial stability. One has no debt, has taken advantage of the obvious and simple means of getting “free money,” has financial stability in case of the loss of money coming in, and understands their cash flow. With the last item in this list one will know how much they can afford to invest and remain financially stable.
The other thing is that these steps provide the proper mindset for investing. There are no questions about how to get rich quickly, no temptations to speculate on penny stocks, and no lack of understanding what it takes to be financially independent. The hard work that it takes to perform all of these steps makes one even more cautious when it comes to investing their hard-earned money, and better prepare one to truly become a prudent investor.