- To invest or not to invest
- Take a good look at your financial situation
- Pay off your high interest debt
- Create an emergency fund
- You are ready to invest!
I know guys and girls, the markets look scary these days, even for professionals! David Einhorn’s hedge Fund, Greenlight, is down 17% through September this year, and Bill Ackman’s one declined 13%. Just in September alone, Bill Ackman lost as much as in 2008, quite impressive right? (You can read more about this Financial gurus in the following Bloomberg article – Ackman, Einhorn LeadHedge Funds on Track to Rival ’08 Slump
– There is no way I am putting a dime in the markets! If these guys are losing their shirt how can I even think about making any profit? – This is what most of you are thinking and I don’t blame you. If you check the charts of the major equity indexes around the world (S&P 500, Shanghai Stock Exchange, Sensex, STOXX50, Nikkei, Footsie) you can get quite frightened.
We are missing something though; we are failing to recognize that we have a huge advantage over the majority of professional portfolio managers. We can, and should, focus in the long-term performance of our investments. We, unlike the professionals, don’t have any of our retributions tied to our short-term performance. We don’t have to meet minimum returns in order to have more bonuses in our salary. Short-term volatility, and market corrections (or even crushes!) shouldn’t be a worry for us, the average investors. Techniques such as DCA and VA (Investing during correction:DCA and VA) can help you to keep on Investing in these times.
In the words of the Oracle of Omaha “Someone’s sitting in the shade today because someone planted a tree a long time ago.” Investing, for the majority of us, should be a long-term affair, and if this is the case, we should be happy to see low equity prices in our accumulation years. So, take the market corrections as great opportunities to accumulate at lower prices. For those closer to retirement, their asset mix should already be adapted to a lower risk profile, but we will discuss this in future posts!
Should you be Investing?
This article tackles the first point in our previous post titled “10 Things Everyone Should Know Before Investing.” In that post I wrote the following passage.
“I know that before I said “anyone with a salary should be investing,” but there are particular cases in which this might not be true, at least for some time. If you have debt at a high interest rate (almost all credit card debt will match this definition) you should pay it off entirely before even thinking about putting any money into the market. It is simple to understand why.
If you owe money and the interests are, fore example, 10%, it doesn’t matter if you can invest in the markets and make an average return of 9%. You are still losing 1% in comparison with the situation in which you pay off all this debt. Now, if you have a mortgage with an interest payment of 3%, you should not pay off the whole mortgage before you start to invest. In this case you can make, using our previous example, 9% investing and only pay 3% interest for the mortgage. So you will make 6% more than if you just completely pay off the mortgage.
The relationship is oversimplified in this explanation, for example that 9% return is not secured; it might vary depending on the market conditions, while the debt will still be due regardless. This is why a lot of radical risk-averse people would prefer to pay off the debt before investing, despite of proven fact that, in average, they are losing money.
The second situation in which you should not invest, even if you have a salary, is that one in which you don’t have an emergency fund. Every rational person should keep between 6 to 12 months of expenses in an account just to make sure that an adverse event does not challenge her financial situation and that she doesn’t need to pull money from her investments. However, if you are debt free, you have an emergency fund, and you have a salary… You better be investing!
I want to extend and methodize this analysis further in order to give a better picture of all the previous financial needs that you should meet before you start investing.
Take a good look at your financial situation
In order to understand how your current finances are and will be, the first step is to make a budget. The great personal finance site Money Crashers has an interesting “12 Steps” article to implement the perfect personal budget. The steps include:
- Decide to start a budget – The first step to solve a problem is to acknowledge that this problem exists!
- Know how much you have – You want to know how much money is in any saving, checking, or investing accounts and/or in any other financial instrument.
- Know how much you make – Write down what is your monthly income.
- Know what you owe – Understanding your monthly recurring debt it’s the logical next step. You should also write down what is the interest in each debt (This is crucial for you so don’t skip it!).
- Determine your net worth – Great moment! You are ready to determine your net worth. Subtract from what you have what you owe… FINANCE IS EASY! Do not worry if you have a negative worth, it is quite ok. Your net worth only accounts for what you own, not for your salary, while it accounts for everything that you owe, even if you owe it in 5 years. Do not stress!
- Determine your average recurring monthly expenses – First, your household expenses (utility bills, food, rent, pets…), add your transport expenses (car insurance, bus ticket, metro ticket…), add your health expenditures (health insurance, medications, gym…), add extra expenditures such as clothing, entertainment…
- Enter this information into a database – You can use Excel or online budgeting tools just like Mint, You Need a Budget, or Mvelopes.
- Look at the bottom line – When you subtract your debt payments and your expenses from your income you find out if you are living within your needs.
- Make adjustments accordingly – If you are spending more than what you are making you have a problem and you need to find ways of cutting your expenditures before you do anything else.
- Adjust categories based on reality – You must adjust when there is a change in reality (pay cut, pay increase, inflation…).
- Pay yourself first – If your finances look good it might be good for you to add another line to expenses, this would be monthly distributions to a saving account. We will talk more in depth about this.
- Track, monitor, and be disciplined – It is as easy to do it as to say it… so, just do it ;).
Now that we know our exact financial situation we can move on.
Pay off your high interest debt
This table shows how much the major equity markets have return since 1900. We can use it as a gauge of what annual average return should you expect from your equity investments. As a rule of thumb, if I have a regional biased, I would payoff any Debt with higher interest rate that the annualized rate of return of the equity markets in my region.
So, if I live in Spain, I would pay off any debt that is higher than 3.6% before I decide to invest. However, we are living in a world where global diversification is getting easier and cheaper to achieve. This is why we should forget our regional biases and invest in globally diversified portfolios.
At the end of the day, I would say that any debt above 4-4.5% should be paid off before you start investing.
Create an emergency fund
After you:
- paid off your debt, and
- optimized your level of expenses to fit your income
you can start building your Emergency fund! An Emergency Fund is an account in which you set aside funds that will be used if an emergency occurs. What can be an emergency? A job loss, illness, injury, home reparation, car crash… The purpose of the emergency fund is to expand your financial security with a safety net that can be utilized instead of credit cards that would require high interests payments.
Personal Finance experts do not agree in the amount of money that you should keep on your emergency fund, some say that you should keep the amount that will cover 3 months Expenses, others 6 months and others 1 year. I personally think that it depends on each case.
A person that has $5,000 monthly expenses will have to keep on an emergency fund of $30,000 (if he wants to have the 6 months option). While a person that has $1,500 monthly expenses only $9,000. The difference of these amounts is drastic, while the emergencies that these two individuals might have will, most likely, be similar in monetary terms. The only case that their emergency might be quite different is if they lose their jobs, in this case, the person with the higher paying job will suffer a bigger financial lose, of course.
What can you get in clean from this? Well, that despite of the simplicity of the concept emergency fund, knowing how much to keep in it is not that straightforward. I would say that keeping at least 6 months of those expenses that you cannot instantly cut should be the lowest amount that you should have. Depending on where you live and the cost of those possible emergencies you should keep more or less above that initial minimum amount.
You are ready to invest!
Now that you meet all the prerequisites, and your financial state looks as healthy as ever you are equipped to start your investment journey. Next step? Finding out what is that you are investing for, but that is a topic for a future post!
Share with us in which step of your journey are you, what challenges are you finding when trying to get your personal finance health in check, and don’t hesitate in asking for more info if you need to!
OpSeeker – Contributing to financial literacy
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