Tuesday, July 7, 2009

Don't Even Think About Investing Until ...

Although the market is still well below the highs it set in 2007, it has rebounded substantially off its March lows. Based on that partial recovery, you may be tempted to think the worst is over and that now would be a great time to invest.

And in truth, it might be. But then again, it may not. After all, the overall economy isn't exactly vibrant. While housing sales were up month to month, they're still dramatically off year-ago levels. Similarly, unemployment was last reported at around 9.5%, the worst in more than 25 years. As a result, even if this is a wonderful time to invest in general, that doesn't necessarily mean you should run right out and buy stocks.

Why not?
If the rest of your financial life isn't in order, investing is an even bigger risk for you than it otherwise would be. After all, you could lose your job and join the swelling ranks of the unemployed. If that or some other financial disaster forced you to pull your money out of stocks at an inopportune time, you might wind up taking out less than you originally invested. At a time when you really needed the money, winding up with less than you started with would compound the tragedy of an already unfortunate circumstance.

That being said, even following the recent market meltdown, investing is a tremendous way to build wealth over the long term. Time is the most important asset you have when it comes to investing. A little bit of cash, regularly and prudently invested for a long period of time, can go a long way toward assuring you can retire comfortably.

That's true even in spite of the recent market meltdown. Just take a look at how strongly these titans have performed over the past 25 years, in spite of what may have happened recently:

Company

Adjusted Close,
April 9, 1984

Adjusted Close,
April 9, 2009

$500 Turned Into ...

Annualized Return

General Electric (NYSE: GE)

$1.07

$11.33

$5,294.39

9.9%

Verizon (NYSE: VZ)

$2.58

$32.10

$6,220.93

10.6%

3M (NYSE: MMM)

$4.21

$53.13

$6,309.98

10.7%

Lockheed Martin (NYSE: LMT)

$5.66

$73.32

$6,477.03

10.8%

Disney (NYSE: DIS)

$1.12

$19.88

$8,875.00

12.2%

McDonald's (NYSE: MCD)

$1.75

$56.67

$16,191.43

14.9%

ExxonMobil (NYSE: XOM)

$1.93

$69.84

$18,093.26

15.4%

Total investment of $3,500:

   

$67,462.02

12.6%

Adjusted for splits and reinvested dividends. Data from Yahoo! Finance as of April 11, 2009.

Strike the right balance
The tough part is figuring out what's appropriate -- how much debt is OK to have, and how large a stash of emergency cash you need before you can be comfortable as an investor. It's a tough problem -- but one you need to solve if you want to be a successful investor amid choppy economic and market conditions like the ones we're living through today. There are no hard and fast rules, but here are some good guidelines to consider:

It's OK to keep some debt, if it's the right kind. Debt that's:

  • at a low interest rate,
  • attached to property or an education that's worth more than you owe on it, and
  • if possible, tax-advantaged

... is generally acceptable. That means a traditional mortgage is probably OK to keep, as are many student loans. Your car loan may be OK, too (though it's not tax-advantaged), as long as you're not underwater and have low-interest financing.

Most other debts, no matter how noble the reason you incurred them, should be considered the equivalent of anchors hanging around your neck. The money you pay to service those debts is money you can't either invest or spend on anything else. The interest you pay simply serves to make your burden heavier -- and to make it all that much tougher to dig yourself out of debt.

Can you save too much?
On the flip side, it's very important to have something stashed away for a rainy day before investing. That way, a job loss or other unexpected emergency won't immediately force you to liquidate your portfolio just to make ends meet.

Socking away too much cash, on the other hand, can also be a problem. The time it takes you to build a substantial cash cushion is time your money isn't invested. Unless you're living substantially below your means, it will take long enough to save up a decent cash cushion. You don't want to extend that period longer than you have to, or you'll risk missing out on the long-term growth potential that stocks provide.

That's why the general rule of thumb is to have three to six months of living expenses socked away before investing. At that level, you have enough saved to handle most of the common curveballs life may throw your way, without investing too much time in building cash.

Build your foundation, and then invest
In spite of the market's periodic hissy fits, over the long run investing is still a critical part of getting you successfully from here to retirement. Investing through those fits is hard enough to do on its own, but without the right foundation it's darn near impossible. When you get the rest of your financial life in order first, it becomes possible to look past the short-term fluctuations and on to the long-run potential that makes investing worthwhile.

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