Some television commercials oversimplify the notion of investing in stocks and managing your own stock portfolio. In one commercial, for example, a man purchases the stock of a clothing designer because many of his daughter’s friends were purchasing the designer’s jeans. In another, a runner in a marathon sees many other runners with the same brand of shoes and decides to purchase the stock of the company who designed the shoe. Much more is involved in purchasing stock if you want to play the stock game intelligently.
Stocks aren’t the only investment vehicle. In the 1970s, many people invested in gold; in the ’80s many focused on oil; in the ’90s stocks were hot; and for the first years of the new millennium real estate was unstoppable. There is no single “right” investment, as all of them go through cycles of highs and lows. A smart investor will always maintain a diversified portfolio.
It is imprudent to purchase stocks when your personal financial condition is unstable. Stocks are not “liquid” investments; they cannot be readily converted into cash without a significant loss of principal. If you are considering investing and your personal financial condition is not stable, you should focus on building as much financial liquidity as possible before you buy stocks. Here is what you should have in place before you go stock hunting.
Adequate insurance coverage. Insurance is not a replacement for financial planning; it is only a means to fill the financial gap until you can afford not to have insurance. Before you go into the insurance agent’s office, learn how to and conduct an “insurance needs analysis” to get an idea of how much insurance you really need. Just as there are predatory lending practices, there are predatory insuring practices where the agent sells you more insurance than you need for the purpose of increasing his or her sales commission. Go to www.reliaquote.com or www.fincalc.com for insurance needs calculators that will assist you in completing an informal analysis for yourself before you see an agent.
Updated estate-plan documents. Is your will, limited power of attorney, health care power of attorney, living will, and (if needed) trust updated? These issues are far more important to complete before investing in the stock market. At www.smartmoney.com/estate, you will find tips, articles and links to additional resources that will benefit you as you plan more wisely for your future.
Clean credit. Do you know your FICO score? Have you printed a copy of your credit report lately? What if you purchase stock only to find out that you have loans in collections deteriorating your FICO score? Go to www.annualcreditreport.com, print all three credit reports before making any investment and clean up your credit.
A working budget. With 60 percent of Americans spending more money than they earn each month, clearly most people are moving backward instead of forward. A budget will tell you how much money you can afford to invest regularly in the market utilizing a disciplined strategy.
Eliminate high-risk debt. If you have credit card debt, have participated in cash advances, or have debt outstanding to the IRS, you should eliminate this debt completely before investing in the market. Some annual percentage rates (APRs) on credit cards can be as high as 30 percent, while stock market returns have a long-term average of 10.4 percent. It makes no sense to earn 10.4 percent in the market (you may earn less or even lose money), only to pay as much as 30 percent for your loan.
An emergency fund. You should have three to six months of living expenses saved—in a high-yield savings account—before you invest in the stock market. In a regular checking account known to have as low as a 0.35 percent interest rate, you are losing money when you factor in inflation. For a good example of a high-yield savings account, go to www.emigrantdirect.com.
Company retirement plan. It’s a good idea to invest in your company’s retirement plan before purchasing stocks outside that plan. Companies often provide a match to your savings and this is essentially “free” money. Be sure to invest at least as much as your company will match. A company retirement program also provides employees with a “tax deferred” account. This refers to investment earnings such as interest, dividends, or capital gains that accumulate free from taxation. Taxes apply only when you withdraw the earnings. Many company retirement plans are “tax deductible,” meaning the value is deductible from the gross amount on which a tax is calculated. Ask your benefits department or a qualified advisor to assist you in selecting an efficient portfolio within your company retirement plan.
Next: Let’s buy some stock!
Ryan C. Mack is founder and CEO of Optimum Capital Management LLC, a wealth management firm in New York City. He can be reached at email@example.com.