Investing is an incredible way to build wealth over time. Even better, it's a path to wealth that's open to almost any adult American, regardless of age, race, sex, career, or education.
The key challenge with it, however, is that investing is as much a mental game as it's a financial one. You need to have both the right state of mind and the right financial foundation in place before you start if you want to maximize your chances of investing successfully.
Within that framework, 2021 can be an incredibly powerful year in your journey. You just might be able to make it the year you start investing if you begin with a plan to get both the mental and financial foundations in place. These six steps will help you get from where you are now to where you need to be to start investing.
1. Understand where your money is going today
In order to invest, you must earn more money than you're spending. If you find yourself in a situation today where you're out of money by the time your next paycheck comes in, you're not yet at the point where you can invest. By understanding where your money is going, you can make better choices designed around which expenses really matter to you, in order to begin investing.
Start by tracking every penny you're spending for two months. Use a spreadsheet, pencil and paper, financial-tracking software -- whatever tool you'll actually keep up with. Your goal is to capture all your costs, so be sure to also include an estimate for your expenses that don't always happen monthly, like insurance, holidays, and birthdays.
2. Decide which of those expenses are really priorities
Once you have a clear picture of where your money is going each month, your next step is to figure out just how important those expenses are to you and your family. Go through your list with three different highlighters -- red, yellow, and green. Highlight red for any expenses that don't matter to you, and use the green for ones that are critically important and that you can't or won't adjust. Highlight all others yellow.
For the red expenses, the answer is simple: Take the actions needed to stop spending money on them. In your own priority list, you decided those costs weren't worth having.
You can keep the green expenses as-is, as long as you can bring your other costs down enough to have cash available to invest. If you can't, you may have to revisit that color coding later. For the expenses highlighted yellow, you have some work to do.
3. Figure out how to get those yellow costs down
Your yellow costs represent expenses you're not ready to get rid of but aren't necessarily critical to your lifestyle. Your objective is to optimize these as much as possible to get them down to what really matters to you. Consider things like downgrading your cable package or cutting the cord entirely and investing in just the streaming services you actually watch. Also, think about making home-brewed coffee or using the free coffee machines at work instead of buying coffee at a specialty store.
Beyond that, decide whether you can get away with raising the temperature in your house a few degrees in the summer and lowering it a few degrees in the winter to save on utility bills. Similarly, ask yourself if store brand or generic products perform well enough to be legitimate replacements for name brands, and make the switch when it makes sense. You're not looking to entirely get rid of these costs, but rather to get them down to where you're maximizing the value you get for your money.
When you're through with this, you're hopefully at the point where the money coming in is more than the money going out each month. If it isn't, go back to step two, recolor some of your yellows as reds and some of your greens as yellows, and start again.
4. Line up and eliminate most of your debts
Now that you have some space between your income and outgoing expenses, you can use that newfound flexibility to reduce your debt burden. Line up all your debts in order from the highest interest rate to the lowest interest rate. On all your debts except the highest-rate one, pay the minimums. On that highest-rate debt, pay as much as you can above and beyond the minimum until it's completely paid off. Then, add what you had been paying to that debt to your new highest-rate debt, and repeat.
Keep that up until most of your debts are gone. Note that you don't have to get rid of all your debts in order to start investing. Ones you may be able to keep have all three of these key characteristics:
- They have a low enough interest rate that you have a reasonable chance of outperforming your interest costs with your investing returns, even after taxes.
- They have a low enough minimum payment that you can easily cover them from your salary while still leaving sufficient flexibility for your other life priorities.
- They serve a clear purpose for your future, such as a place to live, a way of getting or staying employed, or protecting your health.
5. Set aside a little bit for emergencies
The stock market has been a great long-term wealth builder, but its short-term moves can be incredibly volatile, unpredictable, and negative. Because of this, you don't want to have to pull money from your stocks to cover an unexpected cost like a car repair or a surprise trip to the doctor. That's why it's important to have something set aside in savings for emergencies before investing -- so that when (not if) that emergency pops up, you can cover it from those savings.
At a bare minimum, you should have $1,000 socked away in a savings account for emergencies before you even think about investing. Even then, with that little in savings, you'll only want to invest where you have a compelling reason, such as enough to max out your matching contribution from your boss on your 401k. Ultimately, you'll want to put money in your emergency fund to cover three to six months of living expenses before making substantial investments.
6. Get ready to invest for the long term
Once you've worked through these five steps, you'll be in a position where you're financially ready to invest. With your costs of living down, your debts minimized, and a little bit socked away in savings for a rainy day, you'll also be in a much better spot mentally to handle the ups and downs of investing. The last bit of mental preparation you need to do before you actually invest your money is to remember that your stock investments are there for your long-term future -- not to cover tomorrow's costs.
Think about the long-term future prospects of the companies or indexes that you're buying, and make buy, sell, and hold decisions based on those, not based on what their shares are doing today. Similarly, make every stock investment with the intent to hold it for at least five years. Certainly, if the company's prospects or your personal circumstances change before that timer is up, you can sell your shares sooner, but that long-term focus is key to helping you make more rational choices.
Now you're ready to be an investor!
With those six steps accomplished, you're ready to move on to the big time and invest. Fortunately, the act of investing itself isn't all that difficult. In fact, one of the greatest ways to make money in the market over time is to simply buy an index fund every payday with the money you have available to invest. By doing that and sticking with it, you're likely to beat the vast majority of professional money managers over time.
A key reason it may seem more difficult than that is because if you haven't taken care of those six key steps first, you're likely to find it financially or mentally difficult to keep investing when things go wrong. Life happens, the market crashes, and emotions can be hard to manage when it comes to money you're counting on for your near-term needs. So get started today on these steps, and you just might find that 2021 will be the year you're able to start investing.