Deciding whether or not to invest in the stock market, which usually outperforms most other investments over the long run, depends largely on your age and the amount of risk you’re willing to take.
Three questions to determine if you are ready to invest in the stock market:
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Are you already contributing money to a 401(k)? If your employer offers a 401(k), take advantage of it. Make sure you are contributing enough to maximize any matching your employer offers. If your answer is yes, and you still have money available to invest, then go on to the next question.
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Are you free of credit card debt? If you have debt, you need to pay it off before investing.
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Do you have enough savings in your emergency fund? You should have three to six months of living expenses set aside. Do this before putting anything into the stock market.
Five steps to determine if the stock market will work for you:
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Determine your financial goals and how quickly you want to achieve them. What do you want to do with the money you invest? Do you want to pay for your children’s education? Their weddings? Your retirement? A vacation or vacation home? The answer will help you decide whether the stock market is right for you.
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Gauge how much of a risk you want to take. This is the big question because risk is the defining factor when it comes to investing—particularly in the stock market. The more risk you take, the greater chance you’ll have of receiving a bigger return on your investment. If you’re worried about your investments going up and down on a regular basis, then the stock market probably isn’t for you; you’ll want to take a more conservative route. If you’re looking for an average annual return of 10 percent or higher (over the course of your time investing in the stock market), the stock market is where you want to be. But don’t run out and put all your money into a speculative stock you may not understand. There are levels of risk from low to high, and you can change the amount of money invested at any time.
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Learn what types of investments will best meet your investment goals without exceeding the amount of risk you’re willing to take. This is how you decide what combination of stocks, bonds and mutual funds will give you the best return and stay below your risk limit. One rule of thumb for deciding how much to invest in the stock market is to subtract your age from 100. What’s left is the percentage of your investments that should go to stocks or other riskier investments. The rest should be invested more conservatively, such as in bonds or treasury bills.
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Consider your investments carefully. A key concept in investing is diversification. You don’t want all your investments in one spot—you could lose everything. That’s what happened to many employees of Enron, an energy company that went bankrupt in 2001. A majority of its employees had 100 percent of their retirement funds in Enron stock. When the company went belly-up, they wound up with nothing.
A good strategy is to invest in a variety of companies, mutual funds and bonds. Your goal should be to develop a well-diversified portfolio that will hold up during good times and bad (because there will be bad times). Investing regularly over time regardless of what the stock market is doing is called “dollar cost averaging.” You try to buy more stock when the market is lower and less when it’s higher, but generally you don’t try to time the market because there’s no real way to predict what will happen. Just put money in regularly, whether it is every month, every quarter or every year. The best way to make this as painless as possible is to have the money automatically deducted from your paycheck or checking account and deposited into a brokerage account.
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Take responsibility for your investments. It is important to know the basics about the investments you make, as well as to watch them as time goes by and to keep track of whether you’re hitting your financial goals.
Investing in the stock market should be considered a long-term investment—money you don’t plan to touch for 15 to 40 years.
Finally, remember this rule of thumb: If you can’t explain to a ten-year-old child the reason why you’re buying an investment, it is likely you don’t understand it well enough to purchase it.