You don't become an investor overnight. It's a process, and it can take some doing to reach the point where you have the financial foundation to take on investing. But if you're starting to feel like it's time you take the plunge, here's a seven-point checklist for making sure you can afford to invest.
1. Make saving a habit
It may sound simplistic, but you can't invest if you don't save money. This is probably the biggest and most important step to becoming an investor: You have to be willing to live below your means. Humans are really bad at delaying gratification today for a potentially larger reward in the future -- but that's what spending less than you earn is all about. If you want to invest, you have to decide that you will live below your means. And that's a mind-set -- not an actual activity.
2. Cut your spending
So you've decided that you're ready to start saving money -- huge step forward! But now what? You have to figure out how you're going to do it. There are two ways to do this. One is hard and time consuming, and the other is quick but potentially painful. Fine choices, right? I never said this would be easy.
The hard and time-consuming way to save money is to track your spending for a few months and then dig through the data you've accumulated. You can do this with an app that's linked to your accounts, with a spreadsheet of your creation, or even with pen and paper. Regardless, you have to include all of your expenses, from housing and utilities to food and entertainment. The goal is to get a bird's-eye view of your spending and pinpoint where you can lower your expenses. It's a pain, but it can be worthwhile.
The quick and potentially painful way, which is more like ripping off a bandage, is what I recommend. Simply pick a percentage of your salary that you want to save, have that money automatically directed to a savings account, and learn to live on what's left. There'll be an adjustment period where you run out of money too quickly, but you'll figure it out, because you'll have no choice.
You can go whole hog and save 10% to 15% of your take-home pay, but that might be a shock to your finances. A more gentle approach is to start with a lower number -- say, 5% -- and gradually increase that amount by a percentage point every quarter until you reach your savings target. Then you won't feel the difference in spending power as much.
3. Avoid temptation
I'm calling this step three, but it's more like 2B. Let's assume you've started to live below your means. Good! But you also need to protect yourself from human nature (we are human, after all). That means you can't commingle your "saved money" with your "spending money." It has to go somewhere else, or you will most likely spend it, consciously or unconsciously.
The easiest way to do this is to simply open a second account with your current bank. One account, most likely a checking account, will be for spending. The other is for separating your savings out and protecting them from you. If that's not enough, consider opening an account at a different bank so it's extra hard to get at the cash.
4. Safety first
So why have a bank account at all? Wouldn't it make more sense just to open a brokerage account and put all the money there? No, because living below your means doesn't automatically make you ready to invest. There are financial priorities that are higher than investing. Perhaps the highest is accumulating an emergency fund with three to six months' worth of living expenses in it. That's what the separate bank account is really for.
Get yourself to three months, and then you can dial back your emergency fund contributions while you work on some other things. But don't skimp on this step assuming you'll never lose your job or experience a major financial emergency. You really should build up about six months' worth of living expenses, even if you don't do so right away. You never know when life will throw you a nasty curve ball.
5. Protect those who need protection
If you're at No. 5 on the checklist, then you're doing great! Pat yourself on the back, because you're already better off than the majority of Americans who have less than $1,000 in savings. That said, you still aren't ready to invest just yet.
Do you have a family? If the answer is yes, then ask yourself what would happen to them if you died unexpectedly. Would they have enough money to get themselves through the difficult period after you passed? If not, then you should consider getting life insurance before you start investing.
Term life is the cheapest option and probably the appropriate choice for most. You'll have to talk to an insurance agent, but the policy should typically include at least a few years' worth of your salary in coverage. And don't forget to insure your spouse, even if he or she doesn't work; someone has to take care of the kids if you're a single parent, and that costs money.
If no one depends on you for their safety and well-being, then you can skip this part. But if you have loved ones who rely on your income, then life insurance is probably a must. No one wants to consider the possibility of passing before their time, but it can and does happen.
6. Pay down bad debt
If you're thinking you must be ready to invest at this point, I hate to break it to you, but there's another hurdle to clear: your debt. There are different kinds of debt, and some are better than others. For example, credit card debt can be deadly to your financial future, especially considering its high interest rate. However, a home mortgage can be great because interest rates are relatively low, and it can help you build both equity and a solid credit history. So you'll need to assess your debt and how much it's costing you.
Credit cards can charge double-digit interest, and there's virtually no way you'll make double-digit gains every year in the stock market. That's why you'll want to pay off high-interest debt before you start to invest. Debt that goes toward important things like a home, a car, or education is safer to pay off gradually, so long as the interest rates are relatively low.
It can be extremely difficult to rid yourself of debt. However, not only does it lift a huge psychological weight, but it can also allow your money to start working for you instead of against you. Trust me -- it's a wonderful feeling.
7. Bone up on investing
If you've crossed off No. 1 through No. 6, then congratulations: You can afford to invest! You've put in all the hard work it takes to build a solid financial foundation. Of course, now that you can afford to invest, you have to learn how to invest. Otherwise, you might watch your capital disappear before you can say "risk management."
But that's a matter for another checklist!