Updated: Apr 8
I love to talk about stocks and the stock market. It’s fun to learn about new companies and new innovations. But the stock market can also be a very dangerous place for money. It’s FAR easier to lose money than make money if you don’t know what you are doing.
Even if you know what you are doing, there are things you should to do to prepare yourself before you start buying stocks or investing. First, you need to have a plan for what you are trying to accomplish, and you need to take care of some basic financial fundamentals.
Think about your financial goals for your life and seek to develop a comprehensive financial planto guide you to them. A financial plan is your road map for how you want to accomplish your financial goals in the most efficient manner possible, taking into consideration your personal life story.
The profession of Financial Planning exists to help you to build that plan. A financial planner can help you decide when and if you should incorporate stocks into that plan. When you start to seek professional financial advice, it gets confusing quickly. You will see many different titles, financial planner, financial advisor and more. The differences are not well defined. Generally speaking, a financial planner helps you build a road map or financial plan to help you meet your long-term goals. A financial advisor is someone who helps you with any number of investment types, and may or may not consider how that investment fits into your overall situation.
One of the first things a good financial planner will tell you, is that you have no business buying stocks if you don’t have an emergency cash reserve in the bank or a money market fund. Your first goal needs to be a rainy-day fund for the inevitable storm.
If an unexpected expense meant you would be forced to sell your stocks, you shouldn’t have stocks. Stock prices move up and down quickly and are meant to be owned for long-term holding periods. You cannot hold them for long periods if you are buying them before establishing an emergency reserve.
If you are learning about the stock market and want to buy stocks on your own, a financial planner will help you figure out how to do that within your overall financial plan. If you do good research, you may find great stocks on your own, but you still want to make sure they fit with what else you are doing. You want to always be a risk manager. Just in case your personal stock picks don’t pan out, you want to have planned for the worst-case scenario and still be able to reach your goals.
You can use this outline below to help you understand what goes into a typical financial planning process. This is not a replacement for hiring and building a relationship with a professional financial planner.
Quick and Simple Financial Planning Outline
Financial Planning involves determining where you are and where you want to go with your financial life. It involves setting goals and coming up with a plan to accomplish those goals.
Before you get started, it’s best to get an idea of where you stand TODAY by doing the following:
Calculate Your Net Worth
What are your assets? What are your debts?
The difference is your net worth. It’s good to track this, even if it is negative.
Assets — Liabilities = Net Worth
If too much debt is an issue for you, tackle it head-first.
Consider what caused you to incur the debt and if possible, do what is necessary to fix the problem. A negative cycle of spending and debt can be very difficult to climb out from under, and it is even harder alone. If you need help, you have resources available, and a community of people just like you that will help you lift yourself out.
The Dave Ramsey Baby Steps approach has probably helped more people out of debt than anything else in the U.S.
Dave’s “Debt Snowball” technique involves paying paying minimums on every debt except your smallest, and dedicating everything you have to that smallest debt until it is paid off, then moving to the next smallest debt in the same manner.
While the method is not always perfectly efficient mathematically if one considers the varying interest rates on multiple debts, it does provide “psychological efficiency” by providing small victories early in the process. Check out this blog post from 20 Something Finance’s G E Miller for a good perspective on the approach as well as break-down of the baby steps.
Determine Your Cash Flow
How much income do you bring in each month/year? How much goes out?
The difference is your cash flow.
In — Out = Cash Flow
Think of any positive or extra cash flow as money that you can incorporate into your plan to achieve your goals. You may find it helpful to build a budget to keep yourself disciplined about your spending. Mint.com is a popular way to track your spending.
These two activities above serve as your financial benchmark. Over time the numbers will change, allowing you to track your progress towards your goals.
“Brainstorm” a list of your goals in life that will require money such as buying a house, sending kids to college, retirement or a job change, etc. Make a list. Then, begin to visualize how you want these goals to look. Picture each of them in your head — and then stop. Put a pin in it.
We’ll come back to these goals in more detail after we talk about your FIRST TWO GOALS: Cash Reserves and Protection Planning.
Part of goal planning is goal prioritization. Covering these two goals first builds the foundation for your financial plan, preparing you for the storms of life. “Needs Before Greeds” was the phrase my first mentors taught me as a financial planner.
Why did I make you do the brainstorm first?
Because I want you to think about those goals and think about anyone who shares those goals with you. I like to first let you visualize your fun goals — retirement; dropping your kids off at college, buying a house...
Cash Reserve and Protection Planning is NOT FUN to go through, and I don’t want to lose you as we slog through it. If you eat your veggies, you can have dessert.
Cash Reserves (Emergency Fund, Rainy Day Fund, Etc.)
Your first goal should be a cash reserve. Begin to save regularly and systematically (every paycheck, preferably before you pay your regular bills) into a savings account separate from your primary checking account.
“Pay yourself first” — that is, set aside money into your savings account BEFORE you pay the rest of your expenses. If this seems impossible, start small and try to do more each pay period.
As Dave Ramsey recommends, start with trying to save $1,000, then try to get three to six months of expenses saved.
Having a good cash reserve or emergency fund will prevent you from having to use debt when unexpected expenses occur, and will also allow you to invest your money. Investing allows you to benefit from the power of compound interest, but you need to have a cash reserve first.
Your “other first goal” should be protection planning, aka Insurance. Most people know to get auto and home insurance (property and casualty) because a law or a loan requires it. Many people don’t understand what or why they probably need these other insurances as well.
If you have loved ones (e.g., spouse, children, parent) who would suffer financial hardship without you, you need life insurance. You need enough life insurance to provide for your loved ones to survive without you. No matter if you are a bread-winner or stay at home spouse, life would change for your survivors without you.
If you have a spouse or partner, each of you should consider the consequences of each other’s death.
If you have a spouse or partner, each of you should consider the consequences of each other’s death.
o How would your spouse’s financial life change if you were to die tomorrow?
o How would your life change if your spouse died tomorrow?
o What goals would you still want to fund?
o Don’t overlook the stay-at-home spouse. They may not make an income, but think about how life looks for the family without them.
There are many types of life insurance, from term to permanent. You can cover a lot of life for a long time with a term policy to get started.
How much do you need? Determining the right amount is one of the ways a financial planner will help you. At the minimum, you want to cover the amount it would cost to fund your goals for your surviving spouse, partner or children.
Have a thoughtful discussion with yourself and your partner or spouse (if applicable) about what THEY would want to see happen if you died, and vice versa. YOUR SPOUSE should decide how much insurance is on YOU — and YOU should decide how much insurance is on THEM.
In other words, you don’t get to decide how much your spouse gets if you die. You’re dead in this part of the financial plan.
Some of the expenses you will want to consider when determining the appropriate amount of life insurance:
o Paying off debts and mortgage.
o Providing living expenses for a spouse, partner or children.
o Education expenses for children (or even a spouse or partner).
o Additional expenses for childcare, home maintenance, job changes, etc.
o Retirement funding for surviving spouse.
Disability Income Insurance
If you were to get sick or hurt and unable to work, how do you pay the bills? Your ability to earn an income is an asset that you should protect.
What’s your annual income? If you had a machine in your shed that cranked out that much money each year, would you buy insurance on it? That’s what Disability Income Insurance does. It pays you a portion of your lost income if you become sick or hurt and cannot work.
Some people have disability insurance available at work depending on your employer.
Disability Income Insurance won’t replace all of your income in the event of a claim, but rather a percentage per-determined by the contract. Coverage may only be for 20–60% of your base income for example. Can you live off of 20% of your income? What about 60%?
If you are sick or hurt and cannot work, not only do you potentially lose your income,you are probably dealing with additional medical bills. This combination can be catastrophic for a family.
For this reason, anyone who works for income should insure that income against loss from sickness or injury.
Even if you have disability income insurance through work, you should also consider purchasing additional or “supplemental” coverage for the portion of their income that is NOT insured.
As is the case with all insurance, not all policies are created equally. There are various features and benefits that change from policy to policy. For this reason, it’s good to have a financial planner that understands your situation and can help you make a good decision.
Investopedia has a fairly helpful page on Disability Insurance here.
Long-Term Care Insurance
While this isn’t a protection you necessarily always a risk one considers insuring when you are young, it gets quite expensive or impossible to insure it when you are older.
What is it?
Long-Term Care Insurance pays for assisted living, nursing and adult health care if you cannot take care of yourself. While nursing home care comes to mind, many people purchase long-term care to avoid nursing homes. If you have insurance protection, you may be able to afford home healthcare.
Medicare does not pay for long-term care services past 100 days (learn more here). If you meet certain requirements based on need, you can qualify for long-term care services from Medicaid, but many people prefer to avoid such a scenario. You can see more about Medicaid requirements here.
For those that are looking at LTC Insurance, be hyper-aware of how the policy defines “Cognitive Impairment” or brain disorders. Not all policies will treat a claim the same way.
You may want to read this helpful article about What to Look for In A Long-Term Care Policy from the Fisher Center for Alzheimer’s Research Foundation.
A note on Insurability
Most insurance coverages require you to undergo a medical exam or interview to determine if you are insurable. If you’ve had health problems, it may be more expensive or even impossible to obtain coverage.
For this reason, it might be best to consider purchasing insurance as soon as you can afford it, even if you don’t need it until later (LTC for example). You never know if or when you will become uninsurable.
Each of these insurance types can get quite complicated, and that’s why I recommend you work with a Certified Financial Planner® to help determine what is right for you. Get multiple opinions for your protection needs. There are many varying ways to cover these needs. Make sure you are comfortable and understand what you are buying. ASK LOTS OF QUESTIONS.
Goal and Investment Planning
Go back to your “goal storm” from earlier. Let’s begin to think about what each of your goals look like in greater detail.
Define your goals: How much would they cost in today’s dollars? When do you want to achieve them?
Prioritize your goals: If you have more goals than money, which goal will you give up, or delay, to achieve another goal?
How much do your future goals cost in today’s dollars. For example, if your goal is paying for your children’s education, how much does a year of college cost today? If your goal is retirement, how much do you want to spend per year in today’s dollars? What’s your vision of retirement?
What savings or investments do you have going towards those goals already? What are you planning to save between now and then? You’ll want to factor this into your plan.
Once you know your goals, it is time to do the math on how much those goals might cost in the future based on estimated inflation rates. If you are not familiar with how inflation and compound interest work, you can learn more here.
In addition to your expenses, we want to factor in any current and future savings or investments into your plan. You will need to make assumptions on what those investments might be worth in the future, just as you make assumption about what your goals might cost in the future.
All of these calculations require quite a bit of math and would be quite a chore without software. If you are interested in the math behind the calculations, you can learn more at the Investopedia page for “Discounted Cash Flows”.
PersonalCapital.com has free software for retirement and goal planning, but understand that you will likely be solicited for their financial planning and investing services. (I am not associated in any way with Personal Capital). They use the free software as a lead generation technique for their pay services. While these services do employ the use of CFP® professionals, I cannot vouch for the quality of their advice or performance, as I have no experience with it. The business model doesn’t seem to dovetail with the type of intimate long-term relationship I think is important with your financial planner, but I do like the free software.
Financial Planning software can help us calculate what our savings and investments might be worth, as well as what our goals might cost in the future. This information can help you determine if you are saving enough to meet your goals, or whether you need to make changes.
Keep in mind, no software or human can predict the future. All of these calculations require assumptions. For that reason, some financial planners will use additional, more complex modeling techniques to show a wide range of possible scenarios.
Creating a savings and investment plan targeted to achieve each of the goals
It is crucial to develop an investment and savings plan that is based on YOUR goals and resources. This is one of the most important roles a financial planner may play in helping you construct a plan.
You will want to choose an investment mix that is appropriate for your situation and feelings about money are risk. You will also want to consider the tax ramifications of your investment plan (more below).
Most mainstream investments can be lumped into one of 4 categories (keep in mind, this is a over-over-simplification of investing): Cash | Bonds | Stocks | Real Estate.
Think of the four categories in this manner:
Cash is Cash
Bonds are Loans
Stocks and Real Estate are Ownership
Generally speaking, stocks and real estate involve more risk and require a longer-term committment than cash and bonds. If you need the money soon, don’t buy stocks and real estate.
Cash is Cash. The job of cash is to be there when you need it. You don't need your cash to be anything other than available. When I refer to cash, I include checking and savings accounts, money market accounts and anything that has a guaranteed principal value with relatively immediate availability or liquidity.
Bonds are Loans. Bonds are loans to the entity issuing the bond. Generally, interest is paid over the life of the bond, and the principal is paid back at the end of the term.
Stocks and Real Estate are Ownership. Stocks represent a share of ownership in a business. Real Estate represents ownership in land and things attached to the land such as buildings.
Matching Contributions: FREE MONEY
Matching on 401k, 403b or other retirement plans by an employer should be taken advantage of as soon as you are eligible. Even if you are still paying off debt and building your emergency fund, take advantage of the match ASAP.
Taxes are quite complicated. Maybe you already knew that. A financial planner will NOT replace your CPA or tax professional, but they will help you plan strategies that attempt to minimize taxation over your lifetime. In the end, they will still tell you to get final approval from your tax professional.
When saving or investing for retirement or college goals, consider using tax-preferred or deferred investment vehicles if appropriate (401k, 403b, IRA, Roth IRA, 529 Plan, etc.).
The key to understanding the difference between retirement plans is to focus on WHEN money is taxed.
o How is the money taxed on the way in?
o How is the money taxed year to year?
o How is the money taxed on the way out?
A good financial planner considers not only your taxes THIS year, but what they will be in future years and in retirement. If some of your retirement savings is in vehicles that are tax free in retirement such as a Roth IRA, it may help you stay in lower tax brackets year-to-year.
Keep in mind, whenever you use a tax-preferred vehicle, you are giving up a level of flexibility. Make sure you understand the various rules for withdrawal of your investments.
Retirement Plans are The Umbrella, NOT the Investment
It is important to understand that an IRA, 401k or other type of retirement plan ONLY serves as a tax shelter and is not an investment type. The investment is what goes INSIDE of a retirement plan, and that investment can be almost anything at all, just like an investment OUTSIDE of a retirement plan.
For example, you can own cash INSIDE an IRA or 401k, or you can own it OUTSIDE an IRA or 401k. You can own stocks INSIDE an IRA or 401k, or you can own stocks OUTSIDE an IRA or 401k.
The difference is that you will have to pay taxes on the interest and gains OUTSIDE the IRA or 401k. The retirement plan acts as an umbrella sheltering the investment from taxation.
Year-End Tax Planning
It is a good idea to speak to both your CPA and Financial planner each October to conduct annual tax planning to take advantage of possible deductions year to year. Many people make the mistake of waiting until they file in the new year, but many deductions are based on a calendar year and need action before year-end.
Estate and End of Life Planning
This is for the young people too. This section is especially important for anyone with minor children, because if you don’t have a plan (a known will and testament or trust), the state you live in has a default plan for you (and your children).
End of life decisions are one of the most often over-looked aspects of financial planning.
You may have strong opinions about aspects of the end of your life, but it may be too late to decide if it isn’t written down where people know about it. Make your wishes known.
If you are an adult — you owe it to your loved ones to think about a few things and make sure they are communicated clearly in writing in a location everyone knows.
Below is a list of the most important items to consider:
o Who takes care of your children if something happens to you?
o Who do you want making financial decisions if you cannot?
o Who do you want making health care decisions if you cannot?
o How do you feel about life support or other treatments or conditions?
o How do you want your assets distributed?
Probate is the legal process of distributing assets according to a will (or if there is no will), but it is expensive and time consuming. You can take a number of simple steps to avoid probate by the way you title your assets and how you fill out your beneficiary designations. A good financial planner will usually be able to refer you to several estate attorneys for you to choose from, as well as help guide you in making and implementing these decisions.
In the end, it’s best to consult with a professional financial planner to help you determine your best path. This article 10 Questions to Ask a Financial Advisor does a great job of laying out the things you should consider, including questions to ask YOURSELF before asking a financial advisor.
I recommend interviewing several potential advisors to determine who is the best fit for you. Not all financial planners are created equally, and not all of them do the same thing. Ask plenty of questions and write things down so you will remember what they told you.
Once you choose a financial planner, I recommend keeping a journal book to take notes when you meet with them so you can remember what was covered from meeting to meeting. Trust me, they will not be offended, rather they will appreciate that your attention to detail. It is a risk for the planner if a client does not remember a conversation accurately years later. Good notes are a good thing for everyone. Remember, a good financial planner wants you to understand and feel comfortable throughout the process.
Although the comprehensive financial planning process can seem overwhelming, it is well worth going through it. A shaky financial foundation can bleed into every aspect of your life as well as your mental and emotional well-being. Failing to plan is planning to fail as the saying goes, and this is one thing too important left to chance.