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 you shouldn’t be taking this as financial advice. I don’t know you, or your financial situation.
However, the fact is most people will benefit far more from improving their personal finances than from improving their investment portfolio.
I find investing fascinating, but find thinking about my personal finances boring and inconvenient. But in reality, most people can improve their financial lives more by following the steps below than by reading almost any other post on my blog – and these steps have nothing to do with investing.
These steps are simple, but fundamental. You can’t invest if you don’t have your personal finances in order first. Only when you have a solid foundation can you progress on to the world of investing.
1. Don’t create a budget
Often touted as the starting point for anyone offering personal finance advice, creating a budget is seen as the first step in taming your finances. But I’m afraid I disagree.
Budgets are a pain in the arse to create, maintain, and update, and are usually produced using numbers that bear little resemblance to reality anyway. There’s no point recommending something which nobody will do.
They also create a mindset where people feel judged and guilty for spending their own money, and I think this is one of the major reasons why nobody ever makes one. People ensnare themselves in the budgets that they’ve created, and feel pangs of guilt for spending more than some fictional number.
But people do need to know how much they spend.
You need to know what you can afford before you can even get to the question of whether you should you invest or not. How can you possibly make an intelligent financial decision, if you don’t know what you can afford?
Instead of a budget, I’ve found a better way of allocating income is to track where my cash goes. By taking a few minutes every month to track what I’ve spent money on during the month, my spending adjusts without much of a conscious effort.
The beauty of tracking spending rather than budgeting is the gradual mindset shift. I now spend more on the things that are important to me, and less on the trivial things. And it all happens naturally, judgement-free.
There’s no “overspending”, just a fact-based exercise in finding out where money is spent. The result is discovering which activities you think deserve a bigger slice of your monthly income, and prioritising what’s important to you.
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.
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, while cutting back on things that don’t.
The peace of mind that comes with the sense of control over my finances is a huge non-monetary benefit too.
So knowing how much you spend, and what you spend it on should be the first step before investing.
2. 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 pros and cons 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 struggle with motivation and just want to score a few quick wins, it might be best to start with the small debts to feel like you’re making progress.
Whichever method you choose, paying off high interest debt first should be your first step after starting to track your spending. There’s a good reason people recommend paying off high interest debt before investing.
Paying off high-interest debts provides 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.
There is no investment out there that can even come close to that. And it’s risk-free.
3. 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 of an emergency fund 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 has a much lower cost 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 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.
Your financial life should be optimised for sleeping well, not eating well. And nothing brings a good night’s sleep like cash in the bank.
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, say a government worker, then you might not need such a large emergency fund. It’s basically impossible to get fired from the government. If your job is more at risk, say 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 would be sensible to cover the periods 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.
4. 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 falls 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 their life 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 valuable 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.
5. 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 accumulated 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.
6. Get some skin in the game
For those who would rather outsource their investments – either through an IFA, an investment manager, or a robo-adviser, your journey into investing will stop here. You’re paying someone else to do the heavy lifting for you.
For those interested in managing their own money, your journey is just beginning.
For those brave souls venturing forth into the world of investments, my first recommendation would be to get some skin in the game. Nothing focuses the mind like having your own money on the line. 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.
So forget about the idea of starting of with a “play money” account. I’d start off by investing a small amount to see how you react to stock market fluctuations, and to get comfortable with the mechanics of investing.
Stick a small amount of money into the market via a low-cost broker, then get learning. It doesn’t really matter what you invest in, just something to get you in the game.
It sounds like investing money before learning about what to invest in is the wrong way round. But I can assure you that your learning will be 10x more effective with some cash already invested.
7. Do your homework
First off, 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 the basics, and are able to stick with them, then investing your own cash can be an extremely profitable and rewarding activity. The remaining posts in this ‘Basics’ section address all these core concepts of investing.
For those of you who are still interested in managing their own investments, read on to the next post which explores the different things you’re able to invest in: “What can I invest in?”