Before you get started as an investor, you need to earn the right to invest and to earn that right you need to do the following things:
- Determine your current financial situation and estimate your net worth – As with every journey, it must start with identifying clearly where you currently stand. This entails accessing your current financial situation – estimating your current net worth (a computation of the value of all your assets – cash, bank balances, property, jewelry and then subtracting from it all liabilities – credit card debts, car loans) and tracking the flow of your finances (a computation of all income sources – salaries, dividends and then subtracting from it all your expenses – home maintenance, utility bills).
The information gives you an idea of how much you are worth i.e. what you own and what you owe. It also helps you track the flow of funds in and out of your life. These are not just academic exercises; they are to help you make key decisions pertaining to your finances – where cuts can be made to increase funds available for investment.
- Pay off any high interest debts – If the analysis of your current financial situation reveals you have high interest debts, you need to tackle this head-on before you start investing. There is no point investing to earn 10% per annum if you are paying double that or more in interest on your loan. If for example, you have N500,000 in an investment account (at 10% pa) and N500,000 in debt (at 20% pa). You will earn N50,000 in interests while paying out N100,000, resulting in a net interest payment of N50,000. But if you paid off the debt instead of investing, you’d have a net interest payment on zero.
- Establish an emergency savings fund – Life is full of uncertainties, and from time to time unexpected events happen. Imagine, you’ve paid down your debts and have started investing, but you suddenly lose your job. Without an emergency savings, you’d either have to liquidate your investments possibly at a loss or take on new debt. Alas, you are back where you started – no investment and in debt.
We talk about this in more detail in the Foundations of Budgeting and Savings e-Course. However, you just need to keep in mind that most financial planning professionals suggest that an emergency savings should be able to cover your living expenses for 3 – 6 months.
- Develop a financial plan – Now that you know where you are, you must from that point determine how to embark on the journey – shortest route, safest route etc. Developing a financial plan would depend on two things: your goals are and your risk tolerance level.
These are a personal issue. As such, you must resist the idea of developing a financial plan on generalized goals – financial security or comfortable retirement. Refer to lesson 2 for additional guidance on investment objectives. Your risk tolerance level can be ascertained by completing a risk tolerance questionnaire (sample attached).
If you have taken the 4 steps enumerated above; you can now be on your way to building your investment portfolio – implementing the things you’ve learnt on this course.