1. Figure out your goals.
When you first start thinking about this, it seems nebulous. It’s often hard to tangibly state what your goals are, especially if you’re young and single. However, you often find that they day you get married, it feels like a flood of goals hit you at once – buying a house, having a child, and so on.
Here’s what to do to get started.Take out a sheet of paper and list every financial goal you have in your life right now. What are you saving for? What would you like to be saving for? Things that might wind up on this list are retirement, your children’s education, a house down payment, complete debt freedom, a car, “walk away from your job” money, money to start a business, and so on. Some of those will be important to you, some won’t, and you may have some that aren’t even listed there.
Then, take that list and rank them by importance to you (or to you and your spouse). Don’t worry about what society says, but I will say that younger people tend to undervalue the importance of retirement. Other than that, it’s really about what’s important in your own life – not in what society thinks or what someone else sees as being important in life.
I tend to argue in favor of focusing on the top two to four goals. This way, an average person can actually reasonably accomplish those top goals in a reasonable timeframe. Figure out that time frame for those top goals. How much time is it before you reach that goal?
This doesn’t mean that your goals are set in stone. Everyone’s life changes over time and your goals may in fact change. The point is that your investment decisions are led by your goals, so before you even start investing, you should have a good grasp on what your goals are.
In my own life, I have several goals: retirement (targeted for age 60), my children’s college education (targeted for about seventeen years down the road), a new minivan (targeted for 1-2 years from now), and a new house in the countryside (targeted for about twelve years from now). Each of these have a different investment strategy, which we’ll get to in a minute.
2. Know your risk tolerance.
One major piece of the puzzle that people don’t address before they start investing is their risk tolerance. Often, they overestimate their risk tolerance, then find themselves in an investment situation that leaves them feeling very nervous about their financial position.
Spend some time thinking about this. Would you not worry if you woke up and found out that you had lost 5% of your investment if you knew in the long run it would build up in value? How about 20%? If you had $10,000 in stocks, and then over a very bearish month, $2,000 of that vanished, how would you honestly react? Would you take your money out?
The reason this is important is that it is extremely dangerous to be invested in something that exceeds your risk tolerance. If you find yourself waking up in the middle of the night nervous about where your money is, you’re likely to make an emotional move, like taking your money out when it’s about to rebound.
As a general rule of thumb, if you feel nervous about losing money at all, you probably shouldn’t be invested in stocks. Keep it in cash, in either your bank account or in certificates of deposit. Don’t feel weird – my best friend is in this camp.
On the other hand, most people have some degree of risk tolerance, though, and if you find that losing 10% or so won’t make you scared and ready to pull out, then you should dip your toes into stock investment. We’ll get to the specifics later.
3. For short term goals (less than two years or so), keep the money in cash.
That means store it in a savings account or perhaps buy a short term certificate of deposit at a bank – whichever option gets you the best interest rate and enables you to have cash in hand on the day you need it.