This article is part one of a three part series in which we will explore what questions you need to ask yourself to ensure you are ready to invest in the stock market. Next we will discuss how to evaluate a potential stock pick, and finally we will see step by step instructions to set up an online account to buy stocks.
Investing in the stock market can seem daunting. You might be thinking to yourself, “I don’t know how to choose stocks” or “How do I even get started?” Or maybe you think you are completely prepared. You’ve got a couple thousand dollars in the bank, your friend keeps telling you about how much money he’s made on his Tesla shares (while neglecting to show you his overall portfolio performance), and you’ve even downloaded the Robinhood app and set up your account.
No matter where you fall on the confidence spectrum, these basic yet evergreen questions should help temper your expectations and remind you of some of the biggest mistakes new investors (and even seasoned vets) make. After over a decade of investing in the stock market, I still catch myself needing to remember a couple of these from time to time. Below is a list of 5 questions to consider prior to investing your hard earned money in the stock market:
1. Do you have credit card debt?
Investing wisely means comparing the rate of return for various places you can put your money. Rate of return is just another way of describing the gain or loss of an investment over a period of time, expressed as a percentage of the initial investment. This is just like the interest you make on your savings account which is about 0.06% at a brick and morter bank such as Chase or Fifth Third.
If you have credit card debt that rolls from month to month, you should not be investing in the stock market. That may sound harsh, but it’s a simple matter of comparison using the rate of return for your money.
The average rate of return for the stock market is about 8% annually. So if you invested 100 dollars today, you could possibly have 108 dollars in one year. Even so, this growth is not guaranteed, as you could always lose money by investing too. (There are always ways to reduce the riskiness of your stock picks, but we will cover that later.)
In contrast, by paying off a high interest credit card balance, you will earn a guaranteed rate of return on your money equal to the interest rate you are being charged. Oftentimes this interest rate will be in the high teens or low twenties, depending on your credit score and if you’ve missed any credit card payments.
So by paying off a 100 dollar balance on your credit card, you are saving (or making, depending on how you look at it) 20 dollars. You will be spending 20% less money with each payment you make. A little bit of high level calculus shows this is a 12% better rate of return for your money.
Thinking about paying off debt as an investment is key to comparing the various uses of your money. Sometimes it isn’t about making more money, it’s about losing less.
If you have a mortgage or car payment, assuming the interest rate is less than 8%, which it definitely should be, there’s no need to pay it off early. Just keep making your regular payments. But remember, whatever your interest rate is on the loan, if you pay any additional money towards principal (the base amount of the loan), you can guarantee you will be locking in that rate of return, so it’s still a good way to “invest” risk-free.
2. Do you have a “safety net” of at least 3 months worth of living expenses in cash?
At a minimum, you should have 3 months worth of living expenses (in CASH) sitting in a bank account that you could withdraw today for emergency expenses. (For me personally, 6 months of savings is the minimum, but once you get to 3 months worth, you can keep adding to your savings little by little while still investing.)
This means actually sitting down and figuring out how much you spend each month, multiplying it by at least 3, and working towards this goal as a prerequisite to investing in stocks.
Looking for ways to cut spending so you can save your hard-earned money? Check out our article on 10 Beginner Tips to Save Money.
If COVID-19 taught us anything, it’s that the future is completely and utterly unpredictable. You could be laid off or fired at any moment. Your transmission could seize up in your car. You could even be hit by a drunk driver on your way to work. Be prepared for anything. Even a freaking pandemic apparently!
Definitely keep reading and learning more about investing while you get to your safety net goal. Don’t worry, there will ALWAYS be another “hot” stock to buy and a new bandwagon to jump on. You will never miss the boat on investing so long as there are new ideas worth funding.
When Cash Is Not Your Friend
Keeping any amount of cash above your safety net will actually lose you money due to the rate of inflation of currency which is about 2-3% on average. Things cost more over time. So by holding your money in a savings account at a brick and mortar bank, you will be losing about 2-3% of your money per year.
This may be a wise move if you are saving for a car, house, or if you think the stock market is overvalued and may decline in the short term. You can also reduce this deterioration by keeping your savings account at an online bank which offers a higher interest rate. More on that in another post.
3. Do you have access to invest in a company-sponsored 401(k) or IRA?
If your company offers a “401(k) match” program or something similar, I recommend you take advantage of this option prior to allocating any money to individual stock purchases. This is a more passive and reliable way to invest. It puts your investing on auto-pilot and lets you receive the additional “free” money from the company match.
As a reminder, the match that your company contributes does not count towards your annual limit. For 2020, the IRS increased the maximum employee 401(k) annual contribution limit to $19,500. Another goal you could set for yourself is increasing your contributions until you meet this limit each year.
I should note that in my opinion there isn’t any real benefit to contributing to a traditional 401(k) once you’ve got the entire company match if you are a capable investor on your own. The only benefits that come after that point are:
- The auto-pilot nature of 401(k) contributions for people that don’t know enough or care enough to invest themselves
- The psychological benefit from not having to check or re-balance your portfolio
- The tax-penalty of withdrawing early which serves as a mechanism to keep you invested until you’re closer to retirement
One of the benefits of your 401k is also a drawback; you usually cannot pick and choose your own stocks. Usually you will only have a few target date funds to choose from which are actively managed by financial professionals and therefore incur small fees over time which add up in the long run. At a minimum, you should invest as much as your company is willing to match.
4. Have you researched basic fundamentals of the stocks or mutual funds you want to buy?
First and foremost, do you understand how the company makes money? You are literally buying a piece of the business. You wouldn’t buy an entire business simply because it was for sale and you had the requisite dollars. So why would you buy part of a business simply because it was for sale?
You should be knowledgeable about the company’s various revenue streams, the market potential of those revenue streams, and how to evaluate basic financials of the company. This has nothing to do with the price of their stock today, yesterday, or last year. Many factors influence a stock price completely unrelated to the intrinsic value of the company. Sensational news headlines are not reliable predictors of where a stock price is headed.
Yahoo! Finance is a great place to research companies. Their search engine may not have stuck around, but their Finance page is second to none. You can view company profiles, financial history, as well as analyst opinions and news articles about the company all in one place. Most brokerage accounts also have these same features, but Yahoo Finance is still a great resource that I use every single day.
Public companies also need to have an “Investor Relations” department usually found at the top or bottom of their website. They must disclose all financials relevant to their company, including when insiders buy or sell shares of the stock, upcoming product and service launch details, and what they are spending the company money on.
For more ideas, check out my post, Evaluating Stocks: 33 Questions I Use to Research and Select a Stock or Mutual Fund:
Use these common sense questions to pick your next stock or mutual fund. (6 min read)
5. Do you understand the risks?
Any money you put into the stock market is money that may simply be gone tomorrow. Scandals and bankruptcies don’t usually happen that fast in practice, but money in the stock market should always be viewed like this for the sake of conversation.
Time in the Market is Better Than Timing the Market
There is no perfect moment to jump in and buy your stocks. As long as you have done your due diligence and plan to hold your purchases for an appropriate amount of time, you should be comfortable making the purchase while ignoring headlines and comments from your friends and colleagues.
“The best time to plant a tree was 20 years ago. The second best time is now.”
In order to maximize the return you make on your investments, you should try to hold your purchase for at least one full year. This is because you will be taxed at a higher rate if you sell your stock for a gain within the year you bought it. This is called “short-term capital gains tax” and it is applied on the positive difference between the price you sold the stock for and the price you originally paid (basically, your profit).
“Long-term capital gains taxes” are on the profits from the sale of stocks held for more than a year and are lower than short-term capital gains taxes.
The rates will vary depending on your tax bracket, but are in the neighborhood of 25% or lower. So if you sell a stock for $100 more than you bought it for and you held it for less than a year, you will walk away with $75 dollars after the IRS takes their chunk at tax time compared to if you had held it for more than a year and could walk away with $85.
However, the longer you hold your investment without selling, the better off you will generally be. I suggest keeping your stock for a minimum of 3 years before even thinking about selling it. So if you need this cash to buy a house in 2 years, you should seek a safer investment.
There is also risk in not being diversified. Don’t put all your money into one stock, one industry, or even one geographic region. A global, multi-sector approach with holdings of various sized companies provides the most “insurance” against losses across your entire portfolio.
For example, during the dotcom bubble of 2000, tech stocks were wiped out with very few companies left standing. All industries took a hit during the global financial crisis of 2008, but real estate and banking were hardest hit. And with the recent March 2020 market crash due to the COVID-19 pandemic, tourism and oil companies remain beaten down even after five months.
Putting all your eggs in one basket leaves you open to substantial risk. This includes when you invest. Dollar-cost averaging can help you avoid getting burned by big swings in the market.
If you are going to check your stocks every day, you need to have the stomach to handle a drop in price without worrying about it. Conversely, you need to be able to watch an increase in price without getting FOMO and investing at an over-valued price.
The price may go down every day for a week. Or even a month. That can be hard to watch for some people and they sell their stock before ever giving it a chance to really perform well.
Stocks take time to appreciate! Again, these are businesses ran by people inventing and selling new products and services. Give it time. This is why having your safety net is important. You don’t want to get into a situation where you need to sell your stocks in order to pay for an emergency expense.
Stocks seems to be the only thing people want more of when they are marked up. When a stock price falls (i.e. goes on sale for cheaper), they believe they’ve made a mistake and sell their shares. As much as this website focuses on the mind, the real fortunes in the stock market are made when you take psychological pressures and emotions out of the equation.
I hope these questions help you map your journey into the stock market or serve as a compass for when you get lost on the trading floor.
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