In this article, I will discuss the fundamentals you need before investing in the stock market. If done right, investing in the stock market can be an incredibly rewarding decision. However, it's vital that new investors have basic personal finance and market knowledge before investing in the stock market, so as to not minimize the returns they receive once they begin deploying capital.
Unfortunately, this is something that is seen commonly, where new investors quickly become weary of the stock market due to a lack of knowledge and fundamentals. This can ultimately lead to a number of investment mistakes and substantial realized losses.
Therefore, before investing in the stock market, it's essential that you have the right mindset, coupled with the basic personal finance and economic concepts covered in this article.
Fundamental #1: Manage Your Debt
We are not ignorant as people. If you look around at your friends, family, and coworkers, it's not uncommon for several of those people to be in debt. In the U.S. alone, we know that consumer debt is at all-time highs. In fact, the average American has $38,000 in personal debt (not including mortgage debt).
Now, what does this mean for people who are eager to invest in the stock market? Essentially, if you have any debt that does not include low interest debt such as home mortgages or auto loans, do everything in your power to pay off your debt!
To understand why this is the case, imagine that you have $1000 in the bank and you owe your friend, Bob, $1000. Bob charges you $20 a month in interest for this debt. Jack, your other friend, asks if he can borrow $1000. In return, Jack will offer to pay you $10 a month in interest. For simplicity sake, assume no changes in the interest amounts and ignore monetary inflation.
So, what should you do? Should you keep your $1000 in the bank, pay off your debt owed to Bob, or loan all of your money to Jack? Let's take a look at every option and decide which is the best option.
Option 1: Keep $1000 in the bank
Most people would choose this answer as it is the most comfortable option. The average interest paid from the bank is around 0.06% per year. That is just $60, or sixty dollars of interest earned from $1000 in 12 months.
If you were to keep the $1000 in the bank, you would still be paying Bob $240 per year. Therefore, this mere sixty dollars you receive each year will never be enough to sustain your $1000 over time and will never be enough to pay back Bob his $1000.
Option 2: Pay off your debt owed to Bill
This is the best option out of the three, and this is what you need to do before investing. Bob is charging you a very high interest rate. No matter what you invest in, it won't exceed what you are paying him.
The best investment you can make right now, however, is to pay off your debt to Bob. Bob, in this case, symbolizes a loan that has to be repaid, such as your credit card debt.
Option 3: Loan your money to Jack
It is tempting to loan your money to Jack. At that point, you could even call yourself an investor!
However, Jack is going to pay you $10 a month or $120 over one year. Bill is charging you $20 a month or $240 over one year. You would lose $120 for every year you do this! Jack, in this case, symbolizes the stock market.
Prioritize Debt Repayment
Unfortunately, even if you have a little bit of a "nest egg" in the bank that you decide to invest into the stock market, the gains you receive, with an average return of 8-10% per year, would never be enough to beat high interest debt, such as credit card debt, which is around 19% every year. This 8-10% return is also assuming you are investing into a "bull market", or a market that is on the rise for an extended period of time and is economically sound.
If you happen to earn a profit from the stock market, the profitability will never be there and you will continue to lose money until you pay off your debts. In addition, when one invests in the stock market, they can never truly guarantee their returns and should never take an average 8-10% return for granted.
It's important to add, that one should never forget the impact inflation can have on one's returns, with an average of around 2% every year for the last few decades. This would of course cut into the average 8-10% stock market return.
Lastly, if a market crash or recession were to happen, or if the market turned into a "bear market," where the market falls 20% or more and stocks decline in value over a sustained amount of time, your average yearly returns have the potential to be cut in half.
The table below shows the five most common types of debt people in the U.S. hold and the average annual interest rates for them:
Higher interest rates, particularly student loans, medical, and credit card payments are considered "unsecured higher risk debt," and as a result, experience higher interest rates. So, if you happen to have debt, figure out what debt you have to pay off before you start seriously investing your money.
If you have a car loan and a mortgage loan for your house, it may be possible for you to invest in the stock market because it averages 8-10% annually in a bullish market. In the long-term, your return will exceed what you owe in interest every year from your debt, assuming you hold your positions long-term, due to the effects of compound interest.
To summarize, If you have a car and/or mortgage payment, this should not prevent you from investing your money into the stock market. You know yourself and your financial standing better than I do. Regardless, it's something you should (and probably already are) planning to pay off.
Get Into the Habit of Investing
Regardless of how much debt you have, I would, perhaps contrary to prior statements, still invest in the stock market. Even if it's only $50 per month, getting your account setup, getting started, and building the habit of continually investing is arguably crucial towards becoming a successful investor.
If you always have a reason in mind to put off investing, you will regret it months, if not years down the line. Nowadays, because you can get started with investing in the stock market for such a low amount and for free, you can gain experience, gain an appetite for investing, see what it's like to receive dividends, see the market go up and down, and more.
In short, you'll get all of this real-life experience and can do so while still prioritizing paying off your loans.
Fundamental #2: Build and Maintain an Emergency Fund
People usually end up in debt because "something" came up. Most people are not born with debt and it's usually something that you put on yourself. Why? Well, the real reason is because you didn't plan for it!
Say, for example, you had a medical injury that cost you thousands and ultimately left you in debt. Most people don't expect themselves to have a medical injury out of nowhere that ends up costing them thousands and leaving them in debt. Life is unpredictable at times and you should be prepared for it! Although you cannot plan for a medical injury to happen, you can have a safety net in place.
This safety net is what is called as an emergency fund. The money in this account should only be used for emergencies or costs that you don't plan for. As an investor, you have to plan for the unexpected to ensure you stay out of debt! Your emergency fund will therefore prevent the need for debt, or at the very minimum, significantly reduce the amount of debt you may have to borrow in the future.
Eliminate the Need for Debt
Once you are debt free, or in a position where your anticipated returns exceed what you're paying in interest, it's time to fix the real problem. The real problem is that you got into debt in the first place!
Unless you are taking advantage of rewards, there's no use for a credit card. The way to use a credit card is to put all of your expenses on it and every single month you pay the balance in full. You don't pay a penny less! Unless you have this type of discipline, you should not have a credit card in your wallet, as it is a tool you're not going to be using and it will only rack up high interest debt for you otherwise.
Emergency Fund Savings Amount
Most experts agree that at least 6 months of expenses should be held in a liquid account. By liquid, this means cash, such as in a savings account, checking account, or a certificate of deposit. This does not include stocks, bonds, real estate, and other forms of non-liquid assets!
This might take a while, so start with $1000. This is a really good starting point for money that is marked for only emergencies.
Let's say your monthly expenses are $3000. Following the 6-month rule, you should have an emergency fund of $18,000. Once again, you do NOT invest this money! You instead put it in a certificate of deposit or a high-yielding savings account.
Why You Should Never Invest Your Emergency Fund
The stock market is volatile, meaning stock prices move up and down. If you hold individual stocks, you should expect to see a 20% or greater dip at some point during that investment. Even with stocks that many classify as "extremely safe", this is still the case.
Often times, holding on to these short-term losers is the best strategy. This is because the stock market eventually corrects itself and the stock should balance out to its "normal" price once more.
However, with an emergency fund, when you need money, you need it quickly. And, if you're short on cash because of an emergency, you have no choice but to sell the shares you bought in the stock market, even if your investment is down 20% (or more). This is why you do not invest your emergency fund.
Fundamental #3: Understand Inflation, Savings Accounts, and CDs
For most people, saving money in the bank is a guaranteed way to lose it! This is not because you are going to spend it all or because someone will steal it, but simply because of inflation. The effects of inflation day by day, you don't really see it. However, over the long-term, inflation will take a toll on your bank balance.
Think of it like termites. Imagine that there is a piece of wood furniture in your house that you walk by or use everyday, which is home to a termite family. Over the span of a week or month you would not see any substantial termite damage or even notice it at all. However, after a few years, you'd definitely see the impact of termite damage, much like having your money in a low interest rate bank account.
Inflation is therefore defined as an increase in prices over time. Over the last few decades, inflation has been around 2% every year. As a result, this has translated to a decrease in buying power over time. For example, in 1930 a loaf of bread cost $0.09. But in 2018, a loaf of bread cost around $2.30.
From a personal finance perspective, you want to hold emergency fund cash and cash for your regular monthly living expenses, but not have it lose value over time due to inflation. Besides investing your money into the market and into various investment asset classes to protect against inflation (which can be complex and less liquid), you should first understand two common ways to effectively save your cash and have it slowly accrue in value over time: online savings accounts and certificates of deposits (CDs), as discussed below.
Traditional Bank Account and Inflation
There are thousands of locations all over the world for banks of all sizes which offer traditional bank accounts. Some have tens of thousands of employees, numerous paper statements, a continual stream of customer service demands, and much more.
What matters to us, is that all of this stuff is expensive and it's the customer who owns the traditional bank account that pays for a part of it! This, in part, explains why a traditional bank has such a bad interest rate.
As we know already, we can reasonably say that inflation is around 2% per year. In addition, traditional bank accounts pay an average interest of 0.06% per year. This results in a net of negative 1.94% towards your bank account every single year.
For example, the table shows different bank balances and the impacts inflation has on the balances after just one year:
Clearly, you can see that a traditional banking account is an expensive investment, and to top it off, you're paying for the service in the form of a really bad interest rate. Every year you will continue to lose money and the more money you put into these savings accounts, the more you will lose as well.
Online Banking Solutions
Online banks have zero branch locations, zero paper statements, much fewer employees, online customer service, and more, which results in you receiving higher interest rates!
If you're the type of person who goes into your bank branch to deposit checks or likes to socialize with tellers at the bank, an online bank may not fit your requirements. Everyone else, on the other hand, is a great candidate for an online bank. I'm not saying you have to get rid of your traditional bank account. However, an online bank is definitely a better option for your emergency fund because of the higher interest rates you are essentially guaranteed to receive every year.
In short, you want to take this money that you've saved up and set it aside where it's accessible. But, you don't want to be losing it every year knowing fully that your emergency fund is continually shrinking. This is where online bank account providers play a role, as they offer higher interest rates than traditional physical banks.
One thing you should remember before opening any savings account, is that the interest rates they advertise are subject to change. Banks, as private businesses, have a lot of freedom with how they operate and this includes changes to your annual percentage yield (APY) without notification. Fortunately, these interest rates, in general, follow the federal funds rate, which is set by the Federal Reserve (aka the Fed) as a target rate for banks.
Therefore, it's a good idea to keep a close eye on the federal funds rate, as it can help predict and explain why your savings account rate changes. You should also check your monthly account statements to stay on top of your current interest rate. Lastly, keep track of the interest rates from other online banks and ensure your bank(s) offer an interest that is comparable or higher to theirs.
Certificate of Deposit Explained
Certificates of deposit (CDs) are what banks would classify as a safe investment, and rightfully so. CDs are insured by the Federal Deposit Insurance Company (FDIC). This means your money is insured by a government agency and is virtually safe. CDs are timed investments as well, so unlike putting money into a savings account and progressively getting paid until you decide to remove your money, a CD requires a commitment to a variable of time.
For example, if I were to invest in a 6-month CD, the amount of money I would invest would need to stay in the CD for a full 6 months until it reaches what the industry calls the "maturity date." You can then remove your investment and the income that goes along with it or reinvest into another CD. Different banks and credit unions will offer different CD's at different interest rates, so when looking at these, be sure to survey a few different bank ideas.
Also, it's important to note that there are two different rates of investment that you can choose from. A fixed rate and a variable rate. A fixed rate is not going to change. When you commit to the rate of return, it will stay at that rate. A variable rate, on the other hand, has the potential to increase or decrease after committing to the investment. A variable rate, therefore, is risky! I do not ever recommend taking a variable rate. Always take the fixed rate.
CD's are great but sometimes they have early withdrawal fees and it can be somewhat nerve wracking to lock up your money for a set period of time. Therefore, they are not as liquid as savings accounts. With a certificate of deposit, you're essentially agreeing to lock up your money for a set period of time for a fixed interest rate through a bank. It usually offers returns a little bit better than a traditional savings account, but there's also usually some kind of penalty if you withdraw this money early.
Therefore, although there's a use-case for CDs, there's nothing wrong with just sticking with a high-yielding savings account.
The Bottom Line
Through managing your debt obligations, maintaining an adequate emergency fund, and ensuring you're keeping up with the pace of inflation (to the best of your abilities), you'll have a cushion to land on if your investments in the stock market (or elsewhere) perform poorly, which is a possibility for all investors.
If you practice what is taught in this article, you will not be forced to take out your investments in the stock market. This is especially the case if your liquid emergency fund cash is through an online bank which is offering rates higher than the current inflation rate.
In closing, make sure you have these fundamentals down before investing substantial amounts of money. If you do, I can assure you that your investment journey will be far more easier.