In contrast to the “How much do I need to start investing?” question, the “Am I ready to invest?” question is one I don’t get asked as often as I should do.
To preface this post, I should note that I’m not a financial advisor (I’m an investment manager), and per the disclaimer at the bottom of all my posts, you shouldn’t be taking this as financial advice.
Having said that, investing and personal finance tend to go very much hand-in-hand, so I’ll use this post to share with you some general common sense rules to follow before thinking about investing. I’ll also share what’s worked for me personally, in case anyone might find it helpful.
Don’t create a budget
Most outlets for financial advice will advise you to create a budget as a first step, before even thinking about investing. But I disagree. Budgets are a pain in the arse to create and are usually produced using numbers that bear little resemblance to reality anyway. To be honest, there’s no point recommending something that everyone knows they should do, but nobody ever does.
My particular aversion to budgets stems from the fact that they make people feel judged and guilty for spending their own money. And this is one of the major reasons why nobody ever makes one. People trap themselves with the budgets that they’ve created, and start to fear spending more than their made-up number. They end up feeling guilty when they spend over their self-imposed limit.
To take an example, if you like spending more money on holidays, and you enjoy spending money on them, then you shouldn’t be made to feel guilty about not sticking to a budget. It just means that you should be allocating more of your monthly paycheck to spending on holidays, and spending less on things that are less important to you.
But people do need to know how much they spend in order to figure out how much they can afford spend, and how much they can afford to invest.
Instead of a budget, a better way of allocating your income is to just find out what you spend money on. If you take a few minutes every month to find out what you’ve spent money on during the month, you naturally find your spending adjusts without much of a conscious effort from you. You gradually adapt to spending more on the things that are important to you, and less on the less important stuff. It’s completely judgement-free – there’s no “overspending”, it’s just a fact-based exercise in finding out where your money is spent. It’s a great way of finding out what’s important to you, and discovering which activities you think deserve a bigger slice of your monthly income. As long as, in total, you don’t end up spending more than you earn, there are no “limits” on what you can spend. There’s no self-flagellation for going over-budget – just a simple record of where your money has gone. It’s a useful way of gradually nudging yourself to allocate your cash towards activities that are most important to you, whilst not feeling constrained by a budget.
The approach I personally take is to download my bank statements each month and plug them all into an Excel spreadsheet. It takes me about 20 minutes to do each month, but I’ve found the payoff to be huge. Before I started doing this, I’d always had this nagging feeling in the back of my mind that I might be spending too much, I might be buying rubbish I didn’t need, and I might be able to afford the next holiday – but I wasn’t sure. I felt guilty for not knowing this stuff, because shouldn’t this be stuff that everyone knows? After tracking my spending, I know exactly what I can and can’t afford. I’ve spent more on things that I enjoy, whilst cutting back on things that don’t. It brings a real sense of control.
This control is well worth the 20 minutes I spend each month downloading things into Excel, but given the technology used by banks like Monzo and Revolut which can automatically categorise the transactions made on the card, many people may be able to do this even more quickly and achieve the same result.
So knowing how much you spend, and what you spend it on should be the first step before investing.
Pay down high interest debt
There are all sorts of techniques for paying down debt, but they essentially boil down to 2 methods: paying off the highest interest rate debt first, or paying off the smallest value debts first (often called the “snowball method”).
There are benefits and downsides to both, and the route you take depends on your personality. If you’re a numbers person and want to eliminate debt in the fastest way, it’s mathematically best to chip away at the high interest rate debt first. If you just want to score a few quick wins to help motivate you to start paying off the high interest debt, it might be best to start with the small debts to feel like you’re making progress.
Either way, there’s a good reason people recommend paying off high interest debt before investing.
The main point is that paying off your high-interest debts will provide a higher rate of return than investing. Paying off a 15% APR credit card debt is basically the same as making an investment that returns 15% per year after taxes. If you pay off £1000 of your credit card balance, that’s £150 per year in interest charges that you don’t have to pay until the card is paid off. There is no investment out there that can even come close to that with any consistency. And it’s risk-free.
Create an emergency fund
Next up is creating an emergency fund.
This should be kept in a current account or something easily turned into cash (such as premium bonds), but should definitely not be invested.
Its purpose is to cover you in the event of:
- Job loss
- Emergency medical expenses
- Emergency car or home repairs
- Emergency travel
The key word is: emergency.
This isn’t the “I think I could do with a new car” fund, or the “I’ve always wanted to go on safari” fund. It’s to help cover your necessary expenses if you lose your job, or if you have to pay for an emergency without the need to take on high interest debt. Taking money from your emergency fund which earns 0% in a current account is far better than having to borrow money to fund the expense and paying 10%+ in interest.
Whilst it has a very real monetary benefit in allowing you to not have to borrow to meet unexpected expenses, it also brings huge peace of mind. Having a cash buffer will help you worry less about funding emergency expenses, and will help you worry less about the performance of your portfolio. The benefit of being able to sleep well is a massive advantage when constructing your portfolio – nobody wants to be spending sleepless nights worrying about how their investments are performing and whether they’ll have enough money. Your financial life should be organised so you can sleep well before you start worrying about whether you can eat well.
How big should your emergency fund be?
It’s usually advisable to keep anywhere between 3 – 6 months essential spending in your emergency fund, but the size of your emergency fund depends on several factors:
- The safety of your job
If your job is relatively safe, let’s say you’re a government worker, then you might not need such a big emergency fund, as the risk of losing your salary temporarily is lower. If your job is more at risk, let’s say you’re a UK prime minister, then you may want a larger emergency fund.
- The steadiness of your income
If you’re self-employed or you rely heavily on commission/bonuses, then setting aside a larger emergency fund might be sensible, in case of a prolonged period of lower income.
- Whether you have dependents
If you have children who rely on your income, then you may want to set aside more cash to cover any additional expenses as a result of job loss.
- Your own comfort level
If you’re a particularly cautious person by nature, then a higher emergency fund might help you sleep better at night. A comfortable cash reserve can often help people weather the ups and downs in their investments, in which case a larger emergency fund may prevent selling out of investments at the wrong time (a very good thing).
I personally keep around 3 months of essential expenses in a current account earning 0% interest, as I have a relatively stable job, little reliance on bonuses, no dependents, and am not particularly risk averse.
Define what you need to invest for
Why are you investing?
This is one of the most important questions to consider before investing, because it determines what assets you’re going to invest in, and what wrapper you’re going to invest through.
In terms of which wrapper you’re going to use, if you’re investing for retirement and you know that you won’t need the cash until you’re 55+, then it makes sense to invest through a pension scheme – either a company pension or a SIPP. They can have matched contributions and great tax advantages, but you can’t access your money until retirement. If you’re investing for a longer-term goal which is still at least 5-10 years away, but you’ll still need the cash before retirement (e.g. school fees, house deposit), then investing using an ISA or a general investment account would be more appropriate.
In terms of asset allocation, if you’re investing for something that’s a long way away (10 years+), then you can afford to invest towards the higher end of your risk tolerance – i.e. investing in the riskiest assets you’re comfortable with, in order to maximise returns. If you’re investing for something nearer-term, then you’ll be investing in less risky assets to reduce the risk that the portfolio has fallen in value right at the point you need to withdraw the cash.
To give a good example of how important defining your goals are before investing, we need look no further than the high-profile collapse of UK fund manager Neil Woodford. Many investors lost huge sums of money after investing in his flagship Woodford Equity Income Fund, many of them ordinary people who’d trusted him with a large chunk of their savings. Some of the stories of the regular investors were documented in this article, and whilst it’s never pleasant reading about the hardships of others, some good lessons can be learned from their stories. The full article is worth reading, but to summarise: because of the collapse of his fund, investors had to cancel holidays, resort to equity release to cover immediate living expenses, delay urgent home repairs, and forgo putting offers in on new houses.
All these investors had invested in a 100% equity fund, which should always be considered a high-risk investment, but they needed to spend that money in less than 1 year. Their asset allocation was not matched to their time horizon. This is a basic mistake in investing, and one which is easily avoided by defining why you’re investing. If these investors had defined their goals, they’d have realised that they should be keeping any required spending for the next 5 years in cash, and these outcomes could have been avoided.
Choose – DIY or outsource?
Once you know how much you’re able to invest, you’ve got rid of all your high interest debt, you’ve created an emergency fund, and you know why you want to invest, then the next decision to make is whether you’re going to manage your investments yourself, or pay someone else to manage them for you.
If you’ve accumulate a disparate array of previous pension plans and need help consolidating them, or you have complex tax/estate issues, or you’re at an inflection point in your life like retiring and entering drawdown, then employing an independent financial advisor (IFA) might be a good idea.
If you don’t have a complicated financial situation, but you also don’t feel comfortable managing your investments yourself, then you might prefer using either a robo-advisor or a traditional investment manager to manage them on your behalf.
If you simply want to invest and have no other complicated needs, then you can manage your investments yourself, using the guides like the one created by Monevator to choose the right platform for you to invest through.
Given that I’ve got a pretty simple financial situation and am more than comfortable managing my own investments, I’ve gone down the DIY route. Doing it yourself can save you a massive amount in fees every year, which is fantastic for boosting the returns from your investments and helps them to benefit from the power of compounding.
For those that are in a similar position but aren’t confident managing their own investments, a simple robo-advisor should be more than adequate. For those with complex financial issues, a good fee-based financial advisor can be incredibly helpful in saving you time and money in the long run.
Do your homework
If you opt to manage your own investments, my first recommendation would be to forget about the idea of starting of with a “play money” account. Some people suggest creating an account with a fictional amount of cash in it, so you can get your feet wet with how it feels to invest. But in reality, nothing can prepare you for the feeling of losing your own money. As Warren Buffett famously said, “There are certain things that cannot be adequately explained to a virgin, either by words or pictures.” The same goes for investing.
You can always start off by investing a smaller amount to get yourself comfortable.
Once you’ve decided you’re happy making real-life investments, then the real work can begin. “Never invest in something you don’t understand” is a common rule-of-thumb in investing, so the first step is do your homework on managing your own portfolio, so you can understand your own investments.
Before you start investing, you’ll need to have a solid grasp of the basics of investing. For example, you’ll need to know your own personal risk tolerance, you’ll need to research what you should be investing in, how to construct a diversified portfolio, when you should invest, how much to invest, how to monitor/rebalance a portfolio, as well as the logistics of how to actually invest.
It might sound daunting, but you don’t need to have a detailed understanding of every minutiae of portfolio construction. What you do need is a strong grasp of the basic concepts. As long as you really understand these basics, and are able to stick with them, then investing your own cash can be an extremely profitable and rewarding activity. Luckily I’ll be dedicating future posts in this ‘Basics’ section to address these core concepts of investing.
For those of you who are interested in managing your own investments, read on to the next post which explores the different things you’re able to invest in: “What can I invest in?”