The stock market is centuries old and remains one of the most historically proven methods of building wealth. The concept of investing in stocks -- purchasing small pieces of businesses -- is simple, but a lot more goes into having success in the stock market. One big problem is that people can get ahead of themselves, and just like diving into deep waters before you've mastered the shallows, you can quickly get in trouble.
So before investing in stocks, ask yourself: Can I afford to lose this money? It's a simple question you can approach from multiple angles. I'll unpack the mindset that goes into answering this question and explain how to prepare yourself to invest in a way that's sustainable and won't keep you awake at night.
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The literal meaning
Nobody sets out to lose money in the stock market, but there are some simple truths about investing. The first is that markets fluctuate -- they cycle between bull and bear markets. And day to day or even week to week, stock prices will go up or down without much explanation. Additionally, no matter how much time, work, and effort you dedicate to picking your investments, you're extremely unlikely to get them all right.
That means that whether temporary or permanent, you will experience losses. If you want to invest in stocks to make a quick buck, think again. That's more like gambling than investing, and it's an easy way to put yourself in a bind. Are you trying to double your rent money in a hot market? Please don't do it. Are you considering a cash advance on your credit card to buy the dip on something? Don't even think about it.
Investors should have a solid financial foundation before sniffing around the stock market. You don't want the stress of losing the money you truly cannot afford to lose. Clean up high-interest debt like outstanding credit card balances, and have an emergency fund and your living expenses covered before investing so you can do so confidently.
The philosophical meaning
There is another aspect to this question. Volatility is part of investing, whether you buy stocks or any other asset. You can't completely eliminate risk. However, you can control how much risk you expose yourself to, and you should avoid taking on more risk than you're comfortable with. Again, nobody likes seeing red in their account, but it will likely happen at some point. Don't put yourself in a position where you can't sleep at night, or it's on your mind every minute of the day. It's not healthy for you, and such strong emotions can tempt you into making bad decisions.
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You can control your risk exposure based on how you build your portfolio. One way to do this is to diversify by holding different stocks (25 is a good starting point), so you're not putting a lot of eggs in a few baskets. A stock going to zero will hurt more when it's one of three stocks you own versus one of 25. Additionally, you can look at a stock's beta to see how its price tends to move versus the broader market. A low-beta stock is generally less volatile than a high-beta stock.
Six helpful tips to follow
Investing is a personal passion of mine and can be immensely rewarding for your mind, spirit, and wallet. But just like any tool, using it the wrong way can hurt you. To protect yourself, follow these core principles:
1. Don't invest money you might need in the near term.
2. Pay down high-interest debt like credit cards before buying stocks.
3. Build a diversified portfolio of at least 25 stocks.
4. Buy stocks you understand (can you explain to a five-year-old what the business does?).
5. Index funds can be an excellent tool for those who don't have the time or risk tolerance required to buy individual stocks.
6. Avoid riskier stocks if you can't stomach extreme ups and downs.
The stock market can build wealth for anyone, and it's a tool nearly everyone should at least understand and have at their disposal. Look in the mirror and honestly answer that all-important question: Can I afford to lose this money? Once you can do so, from the various angles discussed above, you'll be on your way to your wealth-building journey.
