Follow these simple steps to start investing in the stock market.
In my recent interview with Micah McDonald, he mentioned that he has self-imposed rules for buying and selling his ETFs (exchange-traded funds). I realized that the SR Wife and I had collected a series of self-imposed guidelines for our own investing, as well.
My system is not as detailed as Micah’s, but I like the phrasing — “self-imposed.” These are not “rules to follow, or else you will certainly fail.” No one is going to enforce them. But, they’re guidelines that we’ve set for ourselves to give us clear focus, keep ourselves level-headed, and reduce risk.
I truly feel that these rules will be valuable, especially if you are unfamiliar with investing in the stock market — if you follow these principles, you will have extremely high chances of seeing long-term growth with your investments.
Avoid taking on debt, except for a primary mortgage.
You may be thinking, “What does debt have to do with investing?” Well, debt is part of your complete financial picture. I believe that your whole situation and your specific long-term goals should be considered when making an investment decision. Avoiding debt will help set a strong foundation for building wealth.
What Dave Ramsey Has to Say
One of Dave Ramsey’s baby steps tenets is to pay off your non-mortgage debt before you start investing aggressively. Admittedly, this is an ultra-conservative approach, but, frankly, I think it’s fool-proof.
The idea here is that you’re not helping yourself if you invest money while you have debts accruing interest — especially if it’s high-interest debt like credit cards. In fact, the average APR for cards in the US News database is between 17.06% and 24.08%, which is much higher than the historical average annual return from the US stock market.
If you have high-interest debt like credit card balances, or if you’re using payday loans, these are emergencies, and you need to address these before you begin investing.
Some Dave critics will disagree with my “no debt” opinion. And that’s okay.
I don’t have a problem using credit cards if you know that you can pay off the balance monthly. Likewise, I don’t have a problem with beginning to invest once you pay off or convert your debt to lower interest rates only (especially if you are investing to receive an employer match!). But, these are my self-imposed rules, and it’s how the SR Wife and I operate to make sure we stay on the road towards building wealth.
Maintain a conservative emergency fund.
I recently wrote a detailed article about deciding how much cash reserves you need. Essentially, your emergency fund protects your other assets and helps you stay out of debt. It’s like a form of insurance.
It would be best if you avoided selling or withdrawing your investments unexpectedly because you should.
Only invest in the stock market if you plan to keep it invested for at least 5 years.
In the short term, the stock market is highly volatile. So, frankly, investing in stocks is not appropriate for a short-term time horizon.
Time in the market is critical.
Consider Your Investment Goal
When you decide if you should invest or not, you need to decide your intended goal for that money. Are you planning to use the money to pay your water bill next month? If so, you should not invest it. Are you investing for your retirement in 15 years? Then investing could be a great option!
How Long is Long Enough?
Why did we choose 5 years as our minimum investment timeline? First, look at the S&P 500 historical annual returns since 1927. There’s a lot of green and a lot of red! If you only invest for a short period, you risk needing to withdraw your money after experiencing significant losses.
For 5 year periods from 1926 to 2015, the S&P 500 had a positive return 86% of the time.
You could argue that even 5 years is not a long enough time horizon. However, if you’re not comfortable with using the 5 year mark, you could consider 7 or even 10 years for your minimum.
The point is, the longer your time horizon is, the higher the chances are that your investments will see net positive returns.
Right now, the SR Wife and I are only investing for retirement, so we have no problem meeting the 5 year minimum timeline. However, our other goals are more immediate than 5 years, so we’re working towards those targets each paycheck with our high-interest savings account.
Never invest in single stocks.
This one might be controversial, but it’s the principle we’ve set for ourselves.
What is Unique Risk?
The risk associated with a specific company or stock is called unique risk. For example, if Company A goes bankrupt or has a major scandal, its stock price will suffer severely. If you own a lot of stock in Company A, your investments will be in bad shape.
Unique or “idiosyncratic” risk is “the possibility that the price of an asset may decline due to an event that could specifically affect that asset but not the market as a whole.”
The risk that Company A has a negative outcome is unique to Company A. Company B may be completely unaffected by Company A’s problems, and the rest of the industry or national economy may even be doing quite well! So, to an extent, Company A’s unique risk is avoidable.
What is Market Risk?
Market risk is the chance of unknown adverse outcomes associated with the whole market.
Consider if there is some massive environmental catastrophe or a major national economy defaults on its loans. In that case, many or all industries could be affected. These whole-market risks are not as avoidable.
Why Should You Diversify?
We value diversification so highly that we avoid single stocks altogether.
Mutual funds and ETFs allow investors to own or track multiple stocks or other assets. We exclusively invest in mutual funds and ETFs — I prefer ETFs when possible due to their low expense ratios. In addition, we buy funds across multiple industries, countries, and business sizes to try to reduce market- and industry-specific risks.
By taking this approach, we minimize unique risks as much as possible.
This does mean that we lose some of the gambling-like excitement from investing in a single stock and hoping we picked a “winner.” But, we don’t want to gamble with our retirement funds, so that’s a trade-off we’re happy to make.
If you have the itch to invest in single stocks, I strongly encourage you to pre-determine a maximum percentage of your portfolio to dedicate to single stocks. Then, choose a percentage that you wouldn’t lose sleep over losing. I recommend 5% or less.
Check your investment account balance once per month or less!
I’m a big advocate of being informed and intentional with your finances — it’s the main factor that motivated me to start this site. It’s valuable to track your goals and feel good from the neurotransmitters in your brain when you make progress! But, there are diminishing returns on continually checking your account balances, especially regarding stock market investments.
As we’ve already discussed, the stock market is extremely volatile in the short term. If you’re invested for the long-term, you shouldn’t be concerned about the short-term rollercoaster ups and downs. Checking your investment account values weekly or daily is not helpful, and if anything, it will tempt you to take action when you shouldn’t.
If you see the cable news networks or headlines panicking about the market’s rises and falls, you should ignore them if you’re diversified correctly. You’re in it for the long haul.
Never count your employer match towards your retirement savings rate until you are vested.
What is Employer Benefit Vesting?
Vesting means “to give or earn a right to a present or future payment, asset, or benefit.” Often, companies require employees to wait months or even multiple years until they’re fully vested in all of the job benefits.
Don’t Get Trapped
One of the big reasons I’m a fan of maintaining a large emergency fund is that it buys you a window of independence if needed. You want to feel financially comfortable leaving your job if you find yourself in an unhealthy environment.
Similarly, you don’t want to feel like you’re locked into your job if you’re counting on future vesting for retirement account matching.
Own your investing goals
Consider if your goal is to save 20% of your salary into your 401k and your employer offers up to a 5% match. You could contribute 15%, and your employer would contribute 5%, which would get you to the 20% total you’re shooting for.
But, if you’re not fully vested until year 3 with your employer, you may feel like they’re holding that extra 5% each year over your head to bait you into staying at the company. If things get bad, you don’t want to feel like you have to stay in that role or else set yourself back months or years in your retirement savings progress.
Alternatively, the SR Wife and I use the guideline of not counting the employer match portion towards our goals until we are fully vested.
I’m fully vested at my employer, so we count the match towards our goals. The SR Wife is not yet fully vested, so we contribute the full percentage that we’re targeting. If she ends up staying at her employer until she finally becomes vested, that extra employer match money will be a bonus.
Don’t become a captive to your own retirement account funding.
Avoid withdrawing (or taking a loan) from your retirement accounts before you are retired or semi-retired.
Some financial writers or advisors might tell you that you can’t access your retirement savings until you’re 59-1/2. I’ve previously written about this topic, and there are several ways to access your tax-advantaged accounts early while avoiding the early withdrawal penalty.
I do recommend, though, that you do not withdraw or take a loan from your retirement accounts until you are ready to retire or semi-retire.
It can be tempting to use your nest egg in a pinch or to help fund a large purchase. But, depending on how you do it, you will be subject to taxes, penalties, and the significant opportunity cost of not having that money invested.
Maintain your emergency fund, so you do not have to withdraw your investments earlier than anticipated. Make a promise to yourself not to use your retirement savings before you’re retired.
You can find people in the personal finance world who disagree with each of my points above. It’s certainly possible to break some or all of these rules and still become wealthy. But these are the SR Wife’s rules, and I live by — we self-impose them to hold ourselves accountable, and I recommend these principles for everyone.