Lots of people who begin putting their financial house in proper order quickly begin to wonder when they should start investing in high-return items with risk, particularly the stock market. They see the 10%-12% average annual return, have cash that they want to sock away for a while, and talk themselves into investing before they’re ready.
Whenever I considered investing before I had my house in order, I considered the story of a high-flying friend of mine who was deeply in debt but kept investing his spare money in the stock market. He would brag to me all the time in 1998 and 1999 about how much money he was making and how it was child’s play. In December 2001, he had to file for bankruptcy. Why? He was investing money he didn’t really have, and when the riskiness of his investments became apparent, he was left without a safety net and hit the ground hard.
There are two basic criteria you should look at before you even begin glancing at the stock market. If you haven’t done these things, your financial house isn’t in enough order to afford the risks of putting extra money in the stock market. Instead of investing, you should take your extra money and put it towards meeting these goals first.
You have paid off all high-interest debt. This means you have no outstanding credit card balances that will carry forward and incur finance charges, nor do you have loans outside of the mortgage and student loans. This also includes any balloon mortgages or ARMs on your home. Some would even argue that you should have no debt of any kind prior to dangling your feet into investing, but you should definitely have no high-interest debt.
You have a liquid emergency fund. This fund should, at the bare minimum, be able to cover two months worth of income for you. I recommend that your emergency fund be able to cover two months of income per person on your income tax return, which in my case would be six months. This fund shouldn’t be in a mutual fund or in stocks; it should be in a high-interest savings account or in some other fund that you can immediately liquidate without risk of loss if you need to.
There’s one final thing you should do before jumping in: know what you are doing. I didn’t know very much about the stock market, so I dipped my toes in by starting off with a very popular index fund. I did my research before investing, and watching the account regularly and researching things like dividend payouts and such has taught me quite a lot about mutual funds.
Investing is fun and exciting and can earn great rewards, but don’t kid yourself about the risks. Get your house in order before diving in.