Understanding how to create financial stability is one of the best gifts you can give yourself. But where do you start? Walk by any newsstand and you’ll find a large assortment of publications about money, stock market data, economic trends, and financial advice—most of them written for the experienced investor.
But if you’re a beginner, you can get lost in the technical jargon and give up before you even get started. Or worse, fall back on the advice of friends, relatives or others who may not be as knowledgeable as you think. Fortunately, you don’t have to be an expert to take the first steps. What you really need are sound, user-friendly guidelines that help you make sense of it all so you can create a plan you’re prepared to stick to.
No matter how much or how little money you start with, the important thing is to educate yourself about your options. Naturally, there are no guarantees that you’ll make money from your investments, but if you plan carefully ahead of time, you’ll have a better chance of gaining financial security over the long term.
First of all, remember there are no magic formulas or “perfect” investment products for you to start with. Just invest in something that feels comfortable to you, and don’t agonize over it; it won’t take long for you to feel less confused.
Here are five tips that will help clear the confusion and give you the confidence you need to take those first steps.
Step 1: Clear the Decks Sorry to throw up road blocks before we get to the good stuff, but if you’ve got high credit card debt or your current expenses exceed your income, forget about investing until you’ve “cleared the decks.”
Your first step will be to look for ways to cut back on your unnecessary expenses—think Starbucks. Keep a log of all your out of pocket, miscellaneous expenses for a month or two. You might be surprised at how those little everyday purchases—the ones you can really do without—add up over the months. “Invest in yourself first” by saving that money.
Next, get out your monthly statements and see how much credit debt you’ve racked up. Add up the balances and compare that to the monthly interest rate you’re paying. Many cards have an annual interest rate of up to 18% and more.
Let’s assume you’ve saved a little nest egg of $2,500 but have a credit card balance of at least that amount. Any investment you make would have to earn over 18% after taxes just to break even. Not great odds. In fact, paying off a credit card with an 18% interest rate is a good example of investing in yourself first.
Of course, you can be making reasonable mortgage payments on your home, carry modest credit card debt and still invest a little extra on the side. But don’t think that you can make a killing in the market and use the gains to pay off your credit cards—that’s not investing, it’s gambling. The key is to invest discretionary dollars that you can afford to lose, not money you need to make rent, mortgage, or car payments.
Once you get your day to day spending under control, credit card balances paid down, and can comfortably set aside money in a bank savings account every month, then you are in a position to set more ambitious financial goals. Continued on next tab ... Step 2: Set Realistic Goals Make a list of the goals you wish to meet financially for yourself and your family. They might include: • A home
• A new car
• College
• Retirement
• Your children’s education
• Medical emergencies
• Care for parents
Estimate how many years it will take to meet each specific goal—or work backwards from when the money needs to be available. That way you can choose a savings or investment plan that best fits your time frame. For example, if you know that you will need $40,000 per year to pay your child’s college tuition, starting 10 years from now, that means you need to accumulate at least $4,000 per year, starting now, to meet that goal.
It is important to go through that exercise for each financial goal or future obligation so that you fully understand how much you will need. This will also help to drive home the importance of personal financial planning.
Step 3: Understand the Choices Do a little research and learn about the basic investing tools and accounts, how they differ, and how each will meet your goals. Are you going to invest for the short, medium, or long-term? If short-term, a CD at your local bank or a money-market savings account might be a good place to start. If medium to long-term, you might want to consider stocks, bonds, or mutual funds. It’s important to understand the difference between these financial instruments.
If you buy a stock, you become an “owner” of the company. Your loss or gain will depend on how well the company is run, how well the market performs, and even how the economy is doing overall, since all these factors have an impact on stocks in general.
If you buy bonds, you are in essence loaning the company money on the promise that you will get your money back plus a set amount of interest annually. But bonds are not guaranteed either, so do a little research to understand the risks.
If you choose to buy mutual funds, you are buying shares in a fund that invests in a broad range of stocks, bonds, or both, in essence to spread the risk of gain or loss. It is a sophisticated approach to the old saying, “don’t put all your eggs in the same basket.” Step 4: Determine Your Risk Tolerance How do you pick the savings and investment products that best suit your needs? A lot depends on the goals and timelines you established in Step 2. But more importantly, which decisions will let you sleep easy at night?
Keep the risk/reward ratio in mind. Relatively risk-free savings accounts and CDs won’t reap a high return, but they do give you easy access to your money. Conversely, if you’re saving for retirement in 40 years, you could consider a long-term investment with a higher potential for gain.
Just remember that any investment, whether in stocks, bonds, or mutual funds involves the risk of losing some or all of your money. If you want stocks in your investment portfolio, choosing individual stocks is the riskiest way to go. For beginners, it’s advisable to start with mutual funds. You pay the management team to do all the selecting for you, and diversity should be built-in. Step 5: Diversify When building a portfolio, investors are always advised to diversify their money into various products. That way, if one investment loses money, you’ve got others that could make up for the losses. Even diversifying is no guarantee that your investments won’t suffer if there is a market-wide slump. But your odds are better if you’re diversified than if you make too few choices.
It’s even smart to diversify an investment in mutual funds. As we’ve mentioned, you are already spreading your risk of loss. But mutual funds differ widely. Some invest in high-flying stocks and promise fast growth. Others focus on bonds or foreign investment.
Those are just some simple basics. Now are you ready to dig in a little deeper?
Check out the other articles in Tips for Beginning Investors.
© 2008 Jose D. Roncal |
