Thursday, August 4, 2016

Am I ready to invest in stock market?

I often get the question from friends or former colleagues about investing "How do I start investing in stocks or which stock should I buy?"

Before answering the above question, there is one other question that everyone new to stock market should ask themselves: Am I ready to invest in stock market?  

What does readiness mean here? Well, let me try to explain it in this article, and may be in a later article I can talk about how to get started with stock market investing.

Some people think stock market is a casino where they can make quick money. People who treat stock market as a casino are taking too much risk and essentially gambling with their money. Instead, investing in a stock should be treated similar to investing in a business where you are investing for a long-term return and possibly an income. When you buy a share of a stock, you are buying a share in an underlying company's business. The price of the stock may fluctuate but it should not have any effect on the intrinsic value of the company's business and hence the long-term investment value should increase as the business grows over time. Now, there are always periods of undervaluation and overvaluation where the stock price (black line) can deviate from its earnings line (orange line). However, over a longer period the price should always come back to the earnings line where it would be fairly priced. This can be seen in Ross Stores stock price to earnings graph.


You may also find your stock to be stuck in a period spanning multiple years of no growth or even in decline because the underlying economy or industry is in decline or recession. A typical recession can easily last 2-3 years. During 2008-2009 recession, the US stock market dropped by 40%. If you had money invested in a stock market during that time and you were forced to take it out because you needed the money to pay some unexpected expense, you would have lost 40% of the value of your investment. You should never be forced to sell your investments.

Historically, stock market has grown over long period of time. And historical data for S&P 500 Index (a market index of 500 companies) shows that stock market grew at the rate of 7% annually (inflation adjusted and dividends reinvested).

A 7-8% annual return compounded over the next 10, 20, or 30 years can generate huge amount of gains for a patient long-term investor. The chart below shows S&P 500 growth during 1950-2009 period. The red line shows growth of $1 with dividends reinvested while blue line shows growth without dividends reinvested for the same period. Dividends alone contribute 44% of the total return.


This is why most financial advisors recommend that a retirement account (such as a 401k) for someone in their 20s or 30s should be invested mostly in stocks as the investment duration is very long and there is plenty of time to recover from short-term downturns.

Key point: Stock market is better suited for a long-term investment than short-term. This is also reflected through our US tax code in the form of lower capital gain tax for long-term investments.

Therefore, it would be wise that people invest in stocks (outside of retirement account) only if they don't need the money in short-term, and meet the following requirements:
  • Short-term living expenses are covered by a stable income and/or savings
  • Have sufficient funds set aside for emergencies. Typically, 6-8 months of income
  • Not drowning in high interest consumer debt
  • Have health insurance to cover any major health expenses
Short-term (2-3 years) living expenses should be covered through a stable income source such as a regular paycheck and/or savings stashed in a FDIC insured bank account. There should also be enough margin-of-safety to cover any non-recurring bumps in expenses. In other words, one should not be living paycheck-to-paycheck while investing in a stock market and should have a sufficient buffer.

Additionally, an emergency account separate from a regular checking/savings account should have enough money to cover 6-8 months of expenses, in case of a sudden job loss or an unexpected big expense. This money should not be touched unless it is really an emergency expense.

If one has a consumer debt such as a credit card debt which is typically at high interest rate, it should be paid off  first before even thinking about investing in stocks. The same can be true for car loans depending on the loan amount and interest rate. Think of debt as brakes that will slow you down in building wealth, and the sooner you pay it off the faster your wealth will grow. Also, the return in stock market is not guaranteed whereas savings from debt payoff is a guaranteed return. Consider paying off the high interest debt first and then the low interest debt.

Healthcare is super expensive in US and is one of the major reasons for personal bankruptcies. Without a health insurance, a medical expense can easily snowball and wipe-out years of investment gains.

So, this is what it means to be ready for investing long-term in a stock market. Meeting the above requirements should give you a solid financial foundation to stand-on when investing in stocks, and short-term gyrations in stock prices should not concern you a bit.

Thanks for reading and comments are always welcome.

Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Please use your own judgment or seek a licensed financial advisor before investing. You, the reader, bear responsibility for your own investment and financial decisions.  

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