This week I’ve been on a bit of an investing binge, reading Investing for Dummies (review here), and If You Can (27 pages, insightful, and free). After reading more and more about investing, I’ve realised something… I don’t want to invest.
At least, not yet.
Turns out that there are a few things that you should do before you begin investing your cash in generating assets. So before you start sending Warren Buffet invitations to have an investment duel, let’s look at if you’re ready.
1. You’ve paid off your debts
You’re number one priority before you begin to invest is to pay off your debts or, to put it another way, invest in yourself. The faster you can pay off your debts the less you’ll pay in the long-run.
Anyone you’ve borrowed money from has essentially invested in you; the only reason banks, credit companies, or even your friends, lend you money is because they will get a favourable return.
When we talk about how £1 invested now is worth £5 in ten years, the same goes for your debt. Before you begin investing make sure you’ve paid off any outstanding loans, credit card debt, or IOU notes. The faster you can pay it off the less you’ll actually have to pay in the long run.
The only exception to this rule is your home mortgage (due to the sheer fiscal size of many mortgages), but you should allocate a portion of the money you’re saving each month to pay off your mortgage faster.
2. You’ve got a cushion
After you’ve paid off the majority of your debt, you need to begin saving enough money in safe liquid assets to last six months of living expenses. Investing is all about managing risk, by having half a years living expenses squirreled away is to protect yourself in the case of:
- Market crashes
- Redundancy/ Loss of job
- Other financial disasters
What “liquid” means is that the money is quickly, and easily accessible. Keep it in a very low-risk place as this is your fall back plan.
Most recommend either a high-interest savings account or a mutual money market fund (MMF). Typically MMF pay a much greater rate of interest than a bank’s savings account. Why? Because, unlike banks, MMF’s don’t have as much staff to pay, branches to maintain, or the other overheads that banks have.
However, MMF’s are not insured by the government, and will only let you take out your money in relatively large amounts (Investopedia has a great breakdown of how MMF’s work here).
3. You’ve educated yourself
The financial market is a very dangerous place or the uneducated. At times, it seems to make itself deliberately confusing or hard to understand. Some have argued that this is due to brokers trying to obfuscate the markets to encourage those without MBAs to use their services, but let’s not worry about them.
Before you invest anything make sure that you understand exactly what it is that you’re doing; read a few books, listen to a few investing CDs, and have an understanding of how markets work. Before you trek down any investment roads make sure that you know exactly how the process works and brings you income. This goes for everything; investing in businesses, property, stocks, bonds, and commodities.
4. You understand risk
If you’ve been to any brokering website you’ve seen the warning “the value of your investment can go down as well as up”. It’s incredibly likely that you’ll lose some money through investing, but in the long run (and as long as you’ve done your due diligence) you should average roughly seven per cent increase in your investment a year.
The key word here is average, you will not beat the market. Your investments will fluctuate in value, but typically over a 10 year period, the value of your investment will increase by seven per cent a year.
Before you invest in anything make sure you understand risk. In this instance when we talk about risk we’re talking about the likelihood that an investment won’t reach the goals that you’ve set for it. Thankfully, the level of risk you have can be managed through investing in different sectors, global regions, and types of investment.
You can have a good idea of how risky an investment is based on the companies fiscal reports and through research, here’s a basic checklist of things to look at to see how risky an investment is:
- Look at a company’s price to earnings ratio: If the total price of stocks ([how many stocks a business has] x [price of stocks]) exceeds how much the company earns then the risk of your investment dropping in value is incredibly high
- Compare the company’s assets with its liabilities: If the company’s debt is greater than it’s assets then it’s a bum deal, ideally you’re looking for the debts to be half of the companies assets. A company’s debt should either drop consistently or remain stable from year to year
- Read the company’s previous annual reports: Look at a company’s previous financial annual reports from the past 10 to 15 years, this should give you a good indication of a companies growth potential, and how solid of an investment it’ll be.
Risk is something that can be talked about at length, I’d recommend these pages for further reading:
- Stock Investing for Dummies: Cheat Sheet: Gives a detailed checklist of things you need to research before making an investment
- Finance 101: Understanding Risk Management: Although focused around how businesses should manage risk, this article gives great insight about how to identify a company’s potential risks
- 9 financial risks everyone should understand: A great article from Chuck Jaffe that outlines all the forms of risk when playing the market
5. You’ve decided what you want from investing
There are many things that investing your money can do for you, but before you begin you need to know what it is you want from investing. This typically falls into two categories, investing for growth, and investing for income.
Investing for growth is when you have a set amount that you’d like to have by a certain date. You may be investing for retirement, education, a house, or another large purchase.
Investing for income is for those who are looking to build a cash flow through their investments (like myself). Those looking to do this may be looking for financial freedom, by creating a portfolio large enough that the dividends pay for their expenses.
Depending on what you want from investing your investment plan will differ. Those looking for growth should have a higher tolerance for risk, but will (hopefully) reap better returns.
You’ll be looking for companies that are, unsurprisingly, in a growth phase, increasing both size and profits. Due to the higher risk involved this style of investing also means that you’ll have to keep a closer eye on your portfolio, managing your portfolio to sell those investments when they reach the point you’d like to sell them.
Investing for income is when you focus on buying assets that will generate regular cash flow. With this form of investing you’re looking for stable assets that are unlikely to fluctuate in price much and have a history of paying a high level of dividends/ regularly increasing the amount of dividend paid. This style of investing has a lower level of risk because you’re focusing on established mature companies rather than companies looking to grow.
Often the best advice for most is to use both strategies, but weight your investment in favour of which style aligns with your goals.
If this is something you’ve yet to think about, here are some fantastic articles to get you started:
- Choose your strategy: Value, Growth or Income investing: EuroInvestor outlines the basic forms of investing (and talk about value stocks, which I’ve neglected to)
- Investopedia offers great guides on how to pick growth stocks, and how to pick income stocks
6. You have an investment policy
Once you’ve decided what you want from investing you’re going to need a plan, or policy. This policy will determine how much risk you’re willing to have, what you’ll invest in, when you’ll sell, and when you’ll buy.
Your policy plays two roles; the first is to help you reach your investment goal without getting distracted. The second is to remove the human element of assuming you can beat the market, or of getting too attached to certain investments.
For example, Benjamin Graham (author of The Intelligent Investor) recommends you sell a stock once it has increased in value by 50 per cent, or after two years of owning it. This removes the “maybe it’ll go up if I hold onto it for long enough” and the “I’ll sell it when it reaches it’s peak value” mentalities that cause many investors to make costly mistakes.
Since your level of risk is dependent on how many different sectors, businesses, regions, and types of assets you’ve invested in. So you need to think about how much you’ll invest in each type of asset e.g. 50/50 stocks and bonds. You’ll also want to set some rules for how much you’ve invested in each sector e.g. no more than 10 per cent in one business sector.
7. You trust yourself
Similar to politics, everyone has an opinion on the stock market. If you tell people that you like to invest they’ll come at you with any manner of ideas, tips, and suggestions. One of the most important aspects of investing is being able to trust yourself to make decisions and do your own research.
Due to how popular the stock market is with the general public, news providers will often provide some level of “commentary” on how the market’s doing, hot stock tips, and what they think you should be doing with your cash. It’s the same online, hundreds of thousands of voices all shouting at each other claiming that they have the truth.
Don’t listen to them.
In reality, there are very few analysts, commentators, and opinions that really carry any sort of weight. You should either read relatively unbiased news (such as Reuters) and make your own conclusions or read a variety of news sources. Find a writer you like and that knows what they’re doing and follow them on twitter.
If your favourite writer offers a tip, look at the annual reports yourself and then make a decision. Use news as a kind of metal detector and when it finds something you’re interested in, do the digging yourself.
Good luck on your journey
Here are some more articles to further develop your financial IQ:
How to build a £1,000,000 property portfolio in just 2 years: We spoke to Stephanie Brennan who managed to build a huge property portfolio with just her savings!
5 things every rookie needs to know about stocks, shares, and bonds: A run-down of some essential pieces of knowledge about investing in stocks, shares, and bonds