Investing isn’t for everyone: It requires risk tolerance, not to mention money.
It is necessary, though, if you want to turn small, regular savings contributions into a healthy retirement nest egg. Without investing, your savings will actually lose money over time to inflation.
But you can’t just jump into the stock market without a sufficient financial base, and not all money should be invested. Here are five hurdles you should clear before you start investing.
1. You’re taking advantage of a 401(k) with matching dollars if you can
If you’re offered a 401(k) or other employer-sponsored retirement plan, and your company kicks in matching contributions, you should grab those first and foremost. Often, that match is dollar for dollar up to a certain limit (say, 6% of your salary per year). That’s free money you just don’t walk away from — and it’s an automatic 100% return on your investment.
Because of that, a 401(k) match comes before all of the indicators outlined below; if you have that, you can skip these next steps and start investing immediately within that 401(k).
Once you’ve contributed enough to earn the full match, you can take care of these next steps before investing further.
2. You have paid off any high-interest-rate debt
Investment returns ebb and flow depending on your particular asset allocation (we’ll get to this in a minute) and market fluctuations. But it’s generally considered safe to assume an average annual return of 7% over a long period — for instance, the path to retirement.
That means if you have debt carrying an interest rate higher than 7%, it makes good sense to pay it off before you start investing. The logic: You’re paying more to carry the debt than you’d earn by investing money that could go toward getting rid of the debt.
“Credit cards and lines of credit are usually high-interest debt, while car loans, mortgages and student loans are often at lower fixed rates,” says Katie Brewer, a certified financial planner in Garland, Texas.
3. You have an emergency fund
An emergency fund is money in the bank that keeps you out of a jam if the unexpected pops up: You lose your job, your car needs new tires, the pipes in your house burst during a deep freeze.
Whether you should invest some or all of your emergency fund is up for debate, but there’s not much argument about the importance of having this money set aside — the alternative, in many cases, is running up costly credit card debt. You want to have a fund in place before you start aggressively investing for other goals.
“Typically this fund should hold at least three to six months’ worth of living expenses,” says Brent Dickerson, a certified financial planner in Lubbock, Texas. “This is the time period it typically takes for someone to gain employment after a job loss. It makes little sense to invest for the long term — greater than five years — if you have to liquidate too soon to cover expenses” when an emergency pops up.
4. You’ve outlined your goals (and they’re more than five years away)
Before you start investing, you need to know what you’re investing for. Why? Because, as Dickerson noted above, money for goals that you plan to achieve in five years or less doesn’t belong in the stock market.
“Imagine it is 2007, the stock market is at its peak and you invest your savings to buy a house in 2008. Then, a few months later the great recession hits,” Dickerson says. “Your savings are now down 60% and you either have to sell at an all-time low or wait multiple years before you see your savings return to the price at which you bought.”
That’s not a decision you want to make. Money for short-term goals like a home down payment or next year’s summer vacation should be held in a savings or money market account (go online, where you’ll earn 1%), CDs or bond index funds or ETFs.
5. The words ‘asset allocation’ mean something to you
You don’t just want to invest; you want to invest wisely. That means knowing what your asset allocation should be. Those two little words mean combining factors like your goal, time horizon, risk tolerance and investment selection to help you decide how to spread out your money among your various investment choices.
Those choices include stocks — both U.S. and international, from large companies and small — bonds and alternative investments such as precious metals and real estate. All are typically purchased by way of mutual funds, index funds and exchange-traded funds.
If you’re unsure about how to allocate your assets, a general rule of thumb is to subtract your age from 110. The resulting number is the percentage of your money that should be invested in stocks (also known as equities); the rest should be in fixed-income investments such as bonds. But that’s a very rough approximation. If you can swing it, you’re better off launching your investing career by working with a financial advisor (even just briefly) or using a robo-advisor.
Article originally published here.