Wednesday, March 23, 2011

6 Steps: A Guide for Newbie Investors (Part 1)

Interest in personal finance and investing has grown considerably over the years. Many scour the Internet for advice about the whys, whats, and hows of investing as formal and structured financial training is often either lacking or insufficient. But while helpful and reliable sources of investing information abound online, a practical and cohesive framework for investing is hard to find.

This post is a guide for "newbie" investors, particularly those who are just starting out in their careers. It shows  a sequence of actions beginning investors can follow to manage risk efficiently and maximize returns by boosting capital accumulation, preparing for unpredictable situations, and gaining investing experience. More experienced investors can also use this guide to assess the soundness of their own financial plan and make appropriate adjustments.

1. Eliminate and avoid excessive and expensive debt

Debt places a great burden on your ability to save and accumulate capital for investment. Interest on virtually all consumer debt is debilitatingly high and could add 5,000 pesos upwards to your monthly expenses, money you could instead use for your emergency fund or investments. It's unfortunate that even when global interest rates fall, like what happened as a result of the 2008 financial crisis, interest rates on consumer debt in the Philippines fail to adjust correspondingly. The perennially high-interest environment makes it financially sensible to completely pay off or altogether avoid debt before you even begin building up your cash reserves.

Your debt level is ultimately a function of your income and consumption: the more you earn, the less you need to borrow; the more you spend, the more likely you'll incur debt. And since most individuals have little control over their income, the best way debt can be managed is to control expenses. Avoid purchases that you can't pay for with cash and zero in on your credit card balance; delay major but "necessary" purchases like cars and real property until you're able to pay a sizable down payment and/or have enough income to easily accommodate monthly loan payments.

2. Build up your emergency fund

I have already discussed this topic in detail a couple of weeks ago. An emergency fund is your insurance against unforeseeable financial needs. It is basically a reserve of cash kept in liquid and stable financial instruments like checking accounts or money market funds that you maintain and prioritize over investments in risky assets like stocks and bonds. You can start building up your savings as soon as you have reduced your debt balance to a minimal level and continue until you've accumulated around 8 months' worth of living expenses.

3. Start investing

After establishing a stable emergency fund, you can start investing in higher-yielding instruments. At this point you have to focus on assets with relatively lower risk, like bonds, bond funds, or balanced funds (i.e., a diversified mix of bonds and stocks). The objective of this stage isn't so much to maximize returns, but to gain experience and be more comfortable with owning a portfolio that could lose value in the short term.

Most investors would enter this stage in their twenties or thirties, when the growth in income has significantly outpaced the growth in expenses. However, it is important to start as early as possible to maximize the effects of compounding and the time value of money: it can be done the old-fashioned way, by working hard to earn a promotion, for example, or just by being a more judicious spender. Also, seeing your money grow over the years will give you more confidence in considering riskier but more financially rewarding investments.

Click here for Part 2.

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