As a loud and proud financial geek, my phone often lights up with text messages from friends and relatives with money questions. Sometimes these questions are relatively mundane requiring only simple responses like “Which credit card has the highest cash back rate?” or “How should I pick a savings account?” Others require a phone call because explaining my answer via text would be verbose and quickly devolve into the ramblings of someone who spends too many waking hours reading, writing and thinking about money.
So when a friend sent me the question, “Should I start investing with a robo-advisor?” I knew a call was in order.
As a general rule, I’m not one to talk someone out of a desire to invest, especially considering the epidemic of millennials being disinterested in or slow-to-get involved with the stock market. However, getting your financial life together shouldn’t go from making a basic budget to suddenly investing. There are a few critical steps you need to have taken before you’re ready put money in the stock market.
Step 1: Fully-funded emergency savings
Emergency funds are the backbone of a healthy financial life. Having one ensures you aren’t going to sink into (or deeper into) debt if you find out that lower abdominal pain is really appendicitis or when you realize your dog just ate half a tray of brownies or when your car starts smoking on the freeway. Murphy’s Law wouldn’t be a cliché if there weren’t some truth to the fact anything that can go wrong will go wrong.
Personal finance gurus and enthusiasts alike generally recommend you stash away three to six months of basic living expenses in your emergency fund. Those dealing with debt may feel that’s absolutely impossible, so $1,000 is the commonly accepted amount you should save to mitigate your risk of needing to finance an emergency on your credit card. Another rarely mentioned, but good goal for an emergency fund is to have several months of living expenses in addition to the deductible on your health insurance policy set aside.
Don’t even think about investing until you build up your emergency fund and one of the best ways to be successful is the old set it and forget it strategy.
Step 2: Automate your savings
Thinking to yourself, “I’ll just save what I don’t spend this month” is a recipe for failure. Instead of assuming, or hoping, there would be any money leftover to save by the last day of the month, you should have money routing right from your paycheck into a savings account, before it even hits your checking account. Double points if you have a savings account earning 1.00 percent APY. A best practice is even to go so far as setting up your emergency fund at a different bank than your regular checking account. That way you won’t see how much you have saved when you log in to check your balance, which reduces the temptation to skim a little bit out of your savings to hit up [insert favorite social activity here].
Step 3: Ditch your consumer debt
Got credit card debt? Then now is not the right time to be researching stocks or dumping money into index funds. Your moment will come, but first you should be using that excess cash to knock out your consumer debt. Why? Because paying down debt is a guaranteed return. The stock market certainly isn’t guaranteed to do well the year you start investing. You could lose money. But even if it has a banner year and earns you something like a 12 percent return, you’re probably paying somewhere between 15 to 23 percent in interest on that credit card debt. It’s extremely likely that you will not out earn what you’re paying in interest on your debts.
Let’s say you have a $3,000 balance at 19% and pay $150 a month. It would take you just over two years and cost $635 in interest to pay off your balance.
You found an extra $100 in your monthly budget and wanted to invest it instead of putting it towards your credit card. If you invested $100 a month into an index fund and got an 8 percent return (which is a decent return), you’d have earned $108 on that investment. Not bad. But if you put that $100 towards your credit card each month and paid $250, you’d only pay $352 in interest and pay it off in 14 months. That shaves almost a year of repayment and saves you $238 in interest. Plus, since you dug out of debt a year earlier, you can start putting that $150 towards step 2!
Step 4: Student loan payments under control
Student loans shouldn’t prevent you from investing entirely. Otherwise, it could be a decade or two before you start to dabble in the market, and then you lose the biggest advantage of investing young: time.
However, you should have a repayment plan in place and be contributing more than the minimum amount due each month. Even paying just $10 more above the minimum due could shave months to nearly a year off your repayment plan.
Your repayment plan may be to refinance your student loans, to aggressively pay them down, to get yourself on an income-driven repayment plan or enrolled in a forgiveness option. There are so many ways to handle your student loans, but the important part is that you’ve put in the thought and research so you’re digging out of debt as efficiently as possible.
Once you have the plan in place, you can make the decision if you want extra money in your budget going towards digging out of debt quickly or if you want to invest in the stock market.
Step 5: Be contributing to an employer-matched retirement plan
There’s one notable exception to the advice not to invest while dealing with debt: you can contribute to your employer-matched retirement plan. You are indeed investing when contributing to your retirement plan. You should be sure to max out your employer-match on a 401(k) or 403(b) before you start investing in funds that are geared towards retirement. After all, you’re leaving free money on the table by not taking advantage of an employer match. Talk about a guaranteed ROI.