6-Point Checklist for Making Sure You Can Afford to Invest

If you're itching to start investing in the stock market, who could blame you? It's where Warren Buffett and countless others have made much of their money, and it's just about the best way to build wealth over the long term. But hold your horses: First use these six questions as a checklist to make sure you can afford to invest.

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1. Do you have $25 or more?

Let's start with an easy question. Do you have some extra dollars? You might think you need a lot, as a single share of Warren Buffett's company Berkshire Hathaway recently cost $162 -- or $243,000! -- depending on the class of shares. Amazon.com shares, meanwhile, were recently near $800 a pop, while Priceline Group shares topped $1,500 each. Gobs of companies trade at much lower stock prices, though -- often below $100.

Better still, you can start investing with very little if you use dividend reinvestment plans (colloquially known as "Drips") or direct stock purchase plans (DSPPs). These are maintained by hundreds of major companies, and permit investors to buy company stock (often with sums as small as $25 or $50) and have dividends automatically reinvested in further shares (or partial shares). This can require a lot of record-keeping, for tax purposes, but it's a particularly effective way for those with limited means to build wealth -- and the wealthy can profit from them, too.

2. Are you out of debt?

You can't afford to invest in stocks if you're carrying high-interest-rate debt (such as from credit cards), which can be financially devastating. It's not unusual to be charged annual interest rates of 25% or more, and on $10,000 of debt, that can cost you around $2,500 each year. Any extra dollars you have should be applied to paying off such debt as soon as possible. Indeed, it's worth tackling such debt more aggressively, such as by taking on a part-time job for a while, or significantly cutting back on spending.

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3. Do you have an emergency fund?

You're also not ready to start parking money in the stock market, which is for long-term investments, unless you have an emergency fund standing by. It can be hard to imagine yourself losing your job or getting whacked by a financial crisis such as a costly medical expense or the need for a new transmission for your car, but it happens. Aim to keep about six to nine months' worth of living expenses in an accessible place such as a money-market account. That includes money for housing, food, transportation, utilities, taxes, insurance, and so on. Once your emergency coffers are fully funded, you can think about the stock market.

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4. Do you know what to expect?

You can't afford to invest in stocks if you're not clear on what to expect. For example, you should expect volatility. Over long periods, the stock market's trend has always been upward, but it never goes up in a straight line. There will be occasional temporary downturns, and you need to be prepared to wait them out.

You should know what to expect performance-wise, too. Over many long periods, the stock market has averaged annual returns of 9% or more. Here's how much you might amass over time with an annual average growth rate of 8%:

Calculations by author.

5. Do you appreciate the power of dividends?

If you're new to investing, it's important to understand just how valuable dividend-paying stocks can be in your portfolio. Consider that according to data from the S&P Dow Jones Indices, dividend income made up 33% of the monthly total return of the S&P 500 between 1926 and 2015.

Then there's this: Researchers Eugene Fama and Kenneth French, studying data from 1927 to 2014, found that dividend payers outperformed non-payers, averaging 10.4% annual growth vs. 8.5%. The table below shows how a seemingly modest difference in growth rates can make a big difference over the long run to annual investments of $10,000:

Calculations by author.

Naive investors sometimes assume that dividend stocks are boring, but what they can do for your portfolio is rather exciting. Plus, healthy and growing companies tend to pay out regularly no matter how the economy is doing, giving you income that you can reinvest even during market downturns.

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6. Have you considered index funds?

Finally, know that you can't afford to invest in individual stocks unless you can afford to spend time studying them and keeping up with them, reading many quarterly reports and annual reports and news reports and crunching lots of numbers. Many people don't have the time for that, or the skill for that, or even any interest in that -- which is OK, because there's a solid alternative: index funds.

Index funds are mutual funds or exchange-traded funds (ETFs) that track various indexes of stocks or other securities. Index funds based on much of the stock market, for example, have a long history of outperforming stock mutual funds managed by Wall Street pros. According to Standard & Poor's, as of the end of June 2016, fully 87% of all domestic stock mutual funds underperformed the S&P 1500 Composite Index over the past 10 years, and 85% of large-cap stock funds underperformed the S&P 500. (Index funds can pay dividends, too.)

A handy low-cost broad-market index fund is the SPDR S&P 500 ETF (SPY +1.46%), which distributes your assets across 80% of the U.S. stock market. The Vanguard Total Stock Market ETF (VTI +1.36%) or the Vanguard Total World Stock ETF (VT +1.93%) would, respectively, have you invested in the entire U.S. market, or just about all of the world's stock market.

Whether you opt for index funds, individual stocks, or a combination, you can set yourself up for a much better financial future than if you just socked a little money away and assumed Social Security would take care of the rest. The average Social Security benefit, after all, was recently $1,350 per month, or about $16,000 per year. By investing effectively now, you can enjoy much more income than that in your retirement.