Take These 4 Steps Before You Invest

By Francisco Bermea
March 02, 2010

Investing even modest sums over time can build affluence. But don't put the cart before the horse. You're not ready to build wealth until you understand your overall financial situation and take several key steps to make sure you build on a sound foundation.

1. Get an overall picture of where you stand

The easiest step is always the one people skip. Financial health begins with a realistic household budget that takes into account after-tax income and actual expenses. Once you know how much is coming in and how much is going out, you can make decisions.

Perhaps there's more to work with than you thought.

The pro's trick: Save every receipt and record every expense for a month, then put each expenditure into categories. This exercise surprises everyone who does it.

After you have a sense of the monthly income statement, do what a business would do and take a look at your personal balance sheet. Once the budget is done, calculate net worth: List assets and subtract liabilities. This will show you what you own and what you owe. The more you can put in the assets column -- and the more you can take out of the liabilities side of the books -- the better off you will be.

Bottom line: If your debt far outweighs your assets -- excluding a mortgage -- then you may be better off using disposable income to reduce liabilities, not in trying to build assets by investing.

2. Set Up an Emergency Fund

Everyone needs a cash hoard in case of an emergency. In uncertain times, it's impossible to predict job losses or salary cuts, and even good times can be imperiled by a major unexpected expense or illness. Going into debt during such difficulties will only make matters worse.

An emergency fund should be held in cash or in a stable, liquid investment like a money-market account, not in another investment vehicle that could lose value when you most need the money. Don't try to cheat on this: Your 401(k) plan and the equity in your home don't count: Cash is king. Most financial planners recommend stashing between three and six months of living expenses; more conservative advisers suggest up to a year.

This may seem insurmountable, but accomplishing this savings goal will take time. Long-term goals will instill the discipline to save. If you need a jumpstart, wait for your next tax refund. But get going: You'll be glad you did. Nothing makes you sleep better than money in the bank.
 
 3. Pay Off Bad Debt

Some debt is healthy. No one needs to worry about paying off a mortgage early, and it's certainly alright to put money into the market before your house is paid off. The trick is to eliminate high-interest consumer debt -- the obligations people typically accumulate through credit cards and other consumer borrowing.

The long-term average return for the S&P 500 is about +11% -- less than that after taxes -- which is far below the average 15% rate of interest charged on credit-card debt. It's a sucker's bargain to invest in anything that returns less than your credit card's rate of interest.

Why? Because you'd be paying more in interest on the dollars you've borrowed than you're earning on the dollars you've invested.

If you owe $10,000 at a rate of 15%, you'll pay $1,500 a year in interest. If you invest $10,000 and manage to clear +8%, you'll earn $800. That's a net loss of -$700.

Better to use the $10,000 to pay off the high-interest debt and begin to build a nest egg that can net a real return. Start paying the highest-interest debt first, then any other consumer loans, then student loans.

4. Max Out your 401(k) Contribution

There is one instance when investing before setting up an emergency fund or paying off debt is the savviest choice: When someone is giving you money to invest.

If an employer matches your 401(k) contributions, you're earning a 100% return on your investment instantly, before you accrue any gains from the market.

You don't have to contribute the maximum allowed by the IRS, the idea is simply not to leave any free money on the table. If your employer will match up to 4%, you should contribute 4%. You'll even save a few bucks in taxes, as 401(k) contributions are taken from your paycheck pre-tax.