The idea of investing is exciting to most people. We want to dig in, get our feet wet, and start making some money. But, unfortunately, new investors I talk to are often making a huge mistake when they start.
Instead of having a healthy nest egg stashed away for a rainy day, new investors often take whatever excess cash they have and immediately place it all in whatever investment they wish to make.
This sometimes has no ill effect. Investor continues to invest their excess cash in the stock market, and life is amazing. The profits are rolling in, and their net worth continues to rise.
However, people will run across some expense that wasn’t planned for in most cases. And because they have invested most of the excess capital they have in the stock market, they are stuck with only a couple of options, neither of which are optimal.
They can borrow the money, whether it be via a line of credit or credit card, to pay the expense, or they can pull it out of their investments.
Why saving before investing is absolutely crucial
If an investor chooses to go the route of taking out debt to pay off the expense, as much as they think they are getting ahead with their investments, they are actually falling behind.
If you have to pay for that blown radiator repair with a credit card, you’re more than likely paying 19.99% to hold that balance.
Considering the average return of the stock market is 7%, you’re actually losing money holding that balance on your credit card. Maybe not on your whole portfolio, but on the amount of the expense you are.
Now, not all loans are at that extreme of an interest rate, and if you’ve got a line of credit with an excellent interest rate, it actually may not be a bad idea to invest the money rather than pay off debt. You see this a lot with things like mortgages, depending on interest rates.
The other option you have is to pull money out of your investments to pay the bill. To understand why this is a bad idea, you have to know a little bit about how the stock market works.
Many investors run into a lot of trouble thinking they are investing for the long term by holding an investment for a year or two.
This couldn’t be farther from the truth.
The stock market is absolutely unpredictable over this time frame. However, the stock market has been statistically proven to provide excellent returns over long periods of time. It’s hard to give an exact length, but I would say at the absolute minimum 5 years.
When you are forced to sell assets in your investment portfolio, you haven’t held for long to pay off debt, and you are exposing yourself to more volatility than you should.
This may not always be a detriment, as you may sell when the market is at an unnatural high. But it can also work the other way, and you will be forced to sell when your stocks are trading at a low position.
So now that I know that I should have some money put away, what is the magic number?
I get asked this a ton too, and the answer is that there isn’t a number. The amount you should have set aside for an emergency fund depends on a multitude of things.
I suggest spending half an hour or so and totaling all your monthly expenses, plus anything that you believe may happen in the future. These can include:
- Your mortgage
- Your utility bills
- Your groceries
- Vehicle repairs (may vary based on the age of the vehicle)
- The debt you currently have and the minimum payments on them
The key here is to dig really deep. Leave no stone unturned and figure out exactly what it costs you to live comfortably today.
After you’ve figured all that out and maybe added a little extra just for comfort, you need to factor in your employment. Way back when I was building my emergency fund, I asked myself the following questions about my job:
- What are the chances I lose this job?
- Am I in an industry that is known to have wild swings of employment due to economic conditions?
- If I were to get hurt, what does my employer or benefits package cover?
- If I were to lose my job, how long can I reasonably expect to wait until I get another one?
All of these questions have a huge impact on figuring out exactly how much you need to save. For me, I worked in the oil and gas construction industry. Job security is extremely volatile, and the highs are very high, but the lows are cripplingly low. So I knew that if I lost my job in an economic downturn, it could take months to get a new one.
For that reason, I decided I would try and save up at least three months' worth of expenses before placing money into my brokerage account. I figured with the money received with unemployment insurance, that emergency fund would last me a minimum of 5 months.
What about investment opportunities that pass me by?
This is a widespread concern with new investors. They are often overwhelmed by FOMO (Fear Of Missing Out) and want to jump in right away.
To that, I simply say don’t worry about it. You may be kicking yourself waiting a year to build your emergency fund because you missed investing in a stock that has doubled its value in that same year. But there will be other opportunities. Many others, in fact.
Keep in mind that I am not advocating refraining from investing absolutely anything while saving up for a rainy day. In fact, while I was saving up my emergency fund, I was still contributing to my RRSPS (401k for you folks down in the United States) simply because it was extremely beneficial for me to do so. This is because, at the time, my employer matched a certain portion of my contributions.
You can roll the dice if you want to
As humans, we have a natural tendency to lean towards the shortest route possible for the highest reward. However, saving nothing and investing immediately does have its benefits.
If you don’t run into any hardship in terms of employment or other financial burdens, you’ve got that extra time of capital appreciation in the stock market that those saving up for a rainy day would never have.
But, it is a risk, and risks sometimes translate into negative consequences.
The choice is up to you, and regardless of the route you choose, the fact that you are thinking about investing your money is awesome.
I hope this piece gave you an idea of how much you need to save before investing your money, and I wish you all the best of luck in the future!