When I started investing, I made the common beginner’s mistake – I started by buying and selling stocks.
Over the years, I have learned that buying stocks / mutual funds / real estate / etc., should be the last step in investing. Below, I have highlighted three steps to take before investing. Hopefully, it will help you avoid the mistakes I made.
This article is US-focused, but the same principles apply in any country.
The essence of investment management is the management of risks,
not the management of returns.
Benjamin Graham
Step 1. Build a strong foundation
When I started investing, I did not have an emergency fund. An emergency fund is the money needed to cover 6 – 9 months of living expenses.
Investing without having an emergency fund is like driving without seatbelts. Can you do it – Yes. Is it safe – No!
An emergency fund provides peace of mind. More importantly, it protects your investments. Typically job losses happen during a recession. If you don’t have an emergency fund, you may be forced to sell your investments at a loss during a recession. Hence it is important first to save money and keep it in the bank as an emergency fund.
The second step in building a solid foundation is to get rid of your debts – car loans, personal loans, credit card debts, etc. It is better to save 10% by paying off your loans than trying to earn 10% by investing in stocks.
The only debt I have is a mortgage (home loan) because interest rates on mortgages are typically lower, plus there are tax benefits associated with a mortgage.
Lastly, it is important to have the right kind and amount of insurance.
Step 1 Key Actions:
Build an emergency fund – click here for an overview
Retire all debts (except mortgage) – click here for tips on saving money to help pay off debts
Step 2. Take all the free money
For the longest time, I did not pay attention to my company’s benefits policy.
My company offered a 100% match up to $5,000 for a 401K account. So now I put $5,000 in my 401K account and get $5,000 from my company (that is an instant 100% return on my investment)!
There is such a thing as free lunch; you just have to read your company benefits document!
In addition to 401K, there are other accounts (like HSA) where companies typically match contributions. Make sure you do not miss out on free money.
Governments also give out free money. For example, subsidies on electric vehicles, green appliances, etc. In many states, you can get a smart thermostat for free. An ‘investment’ in a smart thermostat can help you save money every month on utilities.
Step 2 Key Actions:
Take advantage of company contributions / benefits – click here for a link to typical benefits
Avail of government incentives – subsidized / free smart thermostats, Green credits
Step 3. Collect guaranteed returns
Investing is inherently risky – the returns are not guaranteed. In times like these, when markets are choppy, and inflation is rising, guaranteed returns can seem like a godsend.
Although bank deposits provide next to no returns, there are other options to obtain higher guaranteed returns. I-Bonds provide 9.6% returns and have zero risk.
Another major investing for beginners mistake I made was that I did not pay much attention to taxes.
Saving 30% in taxes is much easier and also much better than earning 30% in stocks. When you save 30% in your taxes, you keep the full 30%. When you make 30% in stocks, you effectively get just 20-25% after paying taxes.
I don’t just put in $5,000 (to get the company match above); I max out my 401K to get the full tax-saving benefit.
Step 3 Key Actions:
Invest in high yielding risk-free assets (like I-Bonds) – click here for information on I-Bonds
Maximize tax saving options – here is a list of options: 401K, IRA, HSA, 529 plans, Other options
Step 4. Invest the remaining money
Investing is about maximizing returns while minimizing risks. The above three steps help me minimize risk.
After building a strong foundation, grabbing free money, and pocketing guaranteed returns; I finally invest whatever remains every month in stocks.
There are many ways to invest your money – real estate, stocks, mutual funds, etc. Nowadays, you can add fancy investments like crypto and NFTs to the list.
There is no one right way to invest. I follow a simple investing strategy which I have highlighted in this article.
Good luck with your investment journey…
Recent Update
There was a great comment on this article in the Optimal Finance Daily podcast for advanced financial DIYers:
Regardless of how much debt you have, if your employer is offering any kind of match in a retirement vehicle, prioritize investing just enough to get the full match. This is because that is free money you’re leaving on the table, and depending on how long it will take you to get completely out of debt before you start investing, you could be leaving that money on the table for a long time.
Also, if you have federal student loans or you’re enrolled in an advantageous repayment plan it could make a lot of sense not to pay this debt off as quickly as possible or to delay investing while you’re paying this off, especially if you’re pursuing student loan forgiveness.
My strategy has been to focus on increasing the gap between my income and expenses so that I had more funds available to squash debt. Once I was out of debt I took that money that I was throwing at debt and focused on fully funding my retirement vehicles which for me were my 401(k) Roth IRA and HSA, as well as building up my cash reserves of one year of expenses. After I was satisfied with my cash reserves I put any surplus after funding retirement vehicles into an after-tax brokerage.