Investing 101: Important steps before you invest

By this point in the Investing 101 series, I hope I’ve done an adequate job in conveying the importance of investing and in providing an overview of investing in a nutshell. Maybe you feel ready to jump into some index funds. Great! But before you invest, there are some very important things to take care of first. There’s no point in investing if the rest of your personal finances are in shambles. While I am not a huge fan of step-by-step guides, they do serve as a useful way to delineate goals and priorities for your money. You’ll find similar guides from many other sources. The steps are similar for a reason: most people should prioritize their finances this way.

The steps are as follows:

Step 0. Make a budget.

Having a budget sets the foundation for the rest of your personal finances. At minimum, you need to know where your money is coming from, where it is going, and your income needs to exceed your expenses so that you have some extra money left over every month. If your income does not exceed your expenses, you will need to increase your income, reduce your expenses, or preferably both.

Most people can significantly reduce their expenses by eliminating frivolous spending. This is often preferable to increasing your income. I discuss this more detail in my book and I won’t belabor the point here. Of course, having higher income can allow you to be less rigid in your budget, but don’t be fooled - if you have a spending problem, you will never out-earn your spending. In case you haven’t noticed, my blog is called A Frugal Doctor, and although I am a physician, my lifestyle and expenses are extremely average. I bring my lunch to work, wear old clothes, and drive a 6 year old car currently valued at around $16,000 (the average price of a new car in 2021 is around $40,000). No eating out, designer clothes, fancy cars, or country club memberships for me!

There are many free online tools and/or apps that can help you make a budget. My personal favorites are Mint.com, YNAB, and Personal Capital. You can also just use an excel spreadsheet. You don’t necessarily need a written-down budget, however, if you can keep a reasonable mental budget and do not need to track every last dollar.

Step 0 is complete if your monthly income exceeds your monthly expenses and you have a budget that you can follow.

Step 1. Establish an emergency fund of at least 1 month of living expenses.

Almost all personal finance guides begin with saving enough cash for an emergency fund. For most people, this sits in a checking account where you have access to immediate liquidity.

The reason for an emergency fund is simple. You can’t invest every last penny you have, because you need some money to live off of and pay the bills with! And if you are hit with an unexpected expense, you don’t want to borrow money. On the other hand, we all know that traditional bank accounts pay almost zero interest. Therefore, you want enough money in the emergency fund to pay bills and cover unexpected expenses, but you also don’t want too much money just sitting around earning no returns!

How large should your emergency fund be? Only you can decide. For example, Dave Ramsey, a famous financial author and personality, recommends starting with $1,000 in your emergency fund, and then paying off all debt (except mortgage), before eventually increasing this to be able to cover 3 to 6 months of expenses after you are debt-free. (Source: 7 baby steps).

This is not bad advise per se, but if you followed it to the letter, you would have no more than $1,000 in your checking account, ever… until all your student loans are paid off! For some people, that might be decades. Also, his advice delays investing for far too long.

In my book, I advocate for 1 month of living expenses as the bare minimum size of an emergency fund. This means that should anything bad happen (i.e., job loss), you have enough savings to preserve your immediate living situation (i.e., next month’s rent plus all living expenses) while you work towards a solution.

Beyond this, 3 to 6 months of expenses is probably adequate for most people, depending on your risk tolerance as well as your overall financial situation. Always remember the opportunity cost of not investing your money. Having big numbers in your checking account might be pretty to look at, but is financially costly.

Step 1 is complete if you have at least 1 month of total living expenses saved as an emergency fund.

Step 2. Extra debt payments, starting with highest interest rate debt first.

If you have debt, now is the time to pay it off. After you establish an emergency fund, paying off debt, especially high-interest debt, is the next highest priority for your money.

What is high-interest debt? There’s no strict definition, but certainly any debt that accrues interest in double digit percentages. This includes debt like credit card debt, payday loans, title loans and such. If, for some reason, you have this type of debt, you need to get rid of it ASAP.

Keep in mind that paying off debt represents a guaranteed return on your money at the same rate as the interest. In other words, if all else is equal (and tax considerations are ignored), investing $1,000 for 10% returns is identical to paying $1,000 towards a 10% interest debt.

Should you pay off all debt before investing? This is a much harder question to answer. We know that historically, the S&P 500 returns about 10% annually. Therefore, it stands to reason that if you have lower interest debt, you might be better off investing extra money rather than making extra principal payments. Personally, however, if I had a loan at 9% interest, I would still prefer to take the guaranteed 9% return from loan repayment than invest in the stock market.

As the interest rate decreases, the equation skews more in favor towards investing. It is difficult to put an exact number on how much this is worth. The psychological benefits of debt repayment and being debt-free are worth it to some people.

Step 2 is complete once you no longer have any debt that carry double-digit interest rate. You don’t necessarily have to finish step 2 before moving on to step 3, as most people do these steps simultaneously (see below).

Step 3. If your employer offers retirement plan with matching contributions, such as 401(k) or 403(b), participate and contribute enough to maximize employer match.

If you have an employer sponsored retirement plan with employer matching, you need to contribute to the plan and get the maximum employer match. This is probably the best use of your money, bar none. For example, if an employer offers 1:1 matching up to 5% of your salary, make sure you contribute at least 5% of your salary to the plan. In this case, the employer match gives you a 100% return on your investment. This is not to mention that your contribution is tax-deferred and reduces your income tax burden.

You can make a strong argument for this to be put in step 2 instead. I think the relative priorities of steps 2 and 3 depend on your circumstances, the type of debt you have, and the specifics of your employer plan. For example, if you somehow got sucked into payday loans or other predatory debt, escaping that trap and getting debt free is probably more helpful psychologically. Also, many employer match programs have a long vesting period, so you may not receive the full benefits of the employer match if you decide to change jobs in a year or two. Employer match is pretty amazing, but it doesn’t always double your money immediately. Regardless, I would not advise waiting to pay off all debt before contributing to employer match, just the really predatory ones.

Step 3 is complete once you are contributing enough to receive maximum employer match, if you have one.

Step 4. If step 3 does not maximize your annual tax-deferred retirement contributions, contribute more into your retirement accounts until you reach the annual limit.

You should still maximize your contributions to a 401(k) after you max out your employer match. In 2021, the annual contribution limit is $19,500, plus an additional $6,500 if you are over 50 for 401(k) and 403(b) plans. The annual contribution limit to an IRA is $6,000.

If you have a modest income and your employer’s 401(k) fund selections are exceptionally poor, you may want to consider only contributing enough to get full employer match, and then contributing into an IRA instead up to an annual limit of $6,000 (but this is not available to high income earners, except through a technique known as a backdoor IRA). However, if you have high income, maxing your 401(k) contribution is probably still worthwhile to reduce your tax burden.

Step 4 also applies to people whose employers do not match. If you are self-employed, you can open an individual 401(k) plan. Otherwise, open an IRA and contribute to that.

Step 4 is complete once you have maxed out contributions to the retirement accounts available to you.

Step 5. Decide if you want to pay off all debt early or not.

At this point, you can increase your emergency fund from 1 month to 3 to 6 months of expenses, if you haven’t already.

Depending on your risk aversion and your attitude towards debt, the main decision point now is whether to make early payments on all debt and pay them off, or to start investing with your extra money instead. Again, paying off debt early provides a rate of return equal to the interest rate, whereas investing in a U.S. stock market index returns around 9 to 10% historically. But in debt repayment, the returns are guaranteed, whereas in investing, the returns are not. For this reason, most people aggressively pay off debt even at 5 to 6% interest. But what about debt with 3 or 4% interest? Again, as interest decreases, the equation skews towards investing, as money will probably earn a better return when invested. This also happens to be the interest rate on most mortgages.

Eventually, your goal is to be debt-free, including mortgage. Whether you aggressively pay off all debt early with extra money, or start investing, the end goal is the same. Step 5 is complete once you make a decision.

Step 6. Open a taxable brokerage account and start investing.

You can open a brokerage account at any brokerage (see my overview of three popular ones), and start investing! All of the principles in the previous Investing 101 articles still apply - most people would be best served by investing in a diversified portfolio of stock and bond index funds.

Step 6 never finishes. Over time, your wealth will grow, probably well beyond what you imagined was possible for your income. For people intent on early retirement, step 6 is complete when your nest egg is sufficient to provide for your living expenses forever. This number is the answer to the question “how much do I need to retire?” and is usually 25 to 33x your annual expenses, but that’s a whole different topic (see Chapter 9 - Retirement in my book for a more in-depth discussion).

What steps did A Frugal Doctor follow?

This frugal doctor paid off all debt including mortgage before investing (outside of employer-sponsored, tax-deferred retirement accounts). After student loans, the entirety of our remaining debt was a mortgage at 2.75%, so this approach was extremely conservative. During the years of our accelerated mortgage repayment, the stock market enjoyed a significant bull run. In retrospect, we would have been better off investing instead of paying off our mortgage quickly. Hindsight is always 20/20, however, and the story would have been quite different if the stock market had crashed by 50% during that time, as it had done in 2007 - 2009. Regardless, we became debt-free and now have a healthy investment portfolio.

A few final observations about investing, which I’ve learned over the years. Investing takes time, patience, and discipline, and will not make you rich quickly. If you invest consistently in the stock market for 30 years, you will almost certainly become wealthy. But if you are looking to get rich quick, this isn’t it. You must be willing to tolerate risk. No investment, not even treasury bonds, is completely risk-free, but neither is hiding cash under your mattress. You must be willing to learn and make mistakes along the way. And investing has opportunity cost too, which is often forgotten by those who pursue frugality overzealously. If you invest, you’re making a conscious decision to not spend that money elsewhere. But if you haven’t gone on vacation in 10 years, maybe go on a vacation instead.

In the next (and last) article of the Investing 101 series, we will take a look at how to actually open a brokerage account and start investing. Thanks for reading and happy investing!