If you're itching to start buying stocks, that's great! There are few better ways to build wealth, and most of us will need to amass nest eggs for retirement, since fewer and fewer employers offer generous pensions to their workers.
Don't just jump in, though, without pausing to ask yourself a few questions -- because you might not be as ready to invest as you think you are. Here are five questions you need to answer.
No. 1: Am I free of high-interest rate debt?
Let's start with debt. It's okay and not unusual to have a mortgage you're making payments on, and most home loans these days sport very low interest rates (if yours doesn't, look into refinancing your mortgage).
What's far more problematic is having high-interest rate debt, such as credit card debt. Typical interest rates for credit cards these days are in the mid-teens, which is quite high. But it gets worse: Many card issuers will hike your rate to 25% or even close to 30% if you pay a bill late or commit some other infraction. Rates like that can prevent you from ever getting ahead in life financially and can even lead to financial disaster. So be sure to get out of debt -- high-interest rate debt, at least -- before thinking of investing.
No. 2: Do I have a well-stocked emergency fund?
Next -- are you prepared to face a major financial setback? If, for example, you lose your job, you rack up some big medical bills, or your car needs a new engine, you'll want to be able to stay afloat. That's why anyone who isn't financially independent should have an emergency fund well stocked with at least several months' worth of living expenses. It should be enough to cover all necessities such as food, housing, transportation, taxes, insurance, and so on. If you don't have such a fund, set one up and fill it before starting to build a stock portfolio.
No. 3: Will I be investing for the long term?
It's also important, if you're investing in the stock market, that you're doing so over a long period, perhaps for your retirement 20 years away.
Short-term dollars don't belong in stocks, because the stock market can do anything in the next few years, including crashing just before you need to sell. If you're planning to remain in the market for at least five, if not 10 years, you have a good chance of being able to ride out any downturn. Most corrections and crashes don't last that long (though some do).
No. 4: Do I want to be an active or passive investor?
A fundamental thing to understand, if you want to invest in stocks, is the difference between active and passive investing. Active investors behave as you probably imagine -- researching, buying, and selling various securities relatively frequently over time. Passive investors, on the other hand, favor investments such as low-fee, broad-market index funds, which simply hold the same securities that are in the index they track.
Investing in index funds is no slouch of an investing strategy, either, as you can grow money rather powerfully simply earning roughly the same return as the overall stock market, year in and year out. When actively-managed mutual funds are pitted against their benchmark indexes, they tend to underperform them over long periods, so definitely consider simply socking away meaningful sums regularly in one or more index funds. It takes far less time and skill.
No. 5: Do I have rational expectations?
Finally, be sure that you have reasonable expectations when you invest in stocks. For example, know that the average annual return of the stock market is close to 10% over long periods, so expecting to grow your money by 20% or 30% each year is not reasonable. Similarly, expect volatility. Over long periods, the stock market has always gone up -- but not in a straight line. There are frequent small and brief corrections and less frequent big crashes, with the market plunging as much as 30% or more. Crashes can be scary, but panic selling when the market drops is not a good way to manage your portfolio.
Instead, expect volatility and be prepared to profit from it -- by buying more stocks when they're on sale. Expect individual stocks to surge and stall and occasionally retreat too -- and plan to hang on, as long as the companies' futures remain promising, and their stocks don't seem overvalued. Amazon and Netflix, for example, have been great long-term performers but not without having fallen sharply (and having recovered) at times.
Investing in stocks is a smart (and even fun) thing to do in order to build wealth over time, especially to improve your financial security for retirement. Don't expect Social Security to provide enough income in your golden years. You'll need additional assets of your own, so invest in stocks but only when you're ready.