Before investing in ETFs and stocks, it is important to get your financial house in order. The first step in doing so is to create a budget of your income and expenses. You can do this by looking at the past few months of checkbook and credit card statements. In order to maximize your ability to invest and create wealth, you should try to maximize your income and minimize your expenses in order to maximize your free cash flow (i.e., cash available after all expenses). This free cash flow can be used to invest in stocks, ETFs and other wealth-creating assets.

Next, you should take a detailed look at your personal balance sheet. A balance sheet lists all of your assets and liabilities. Assets include physical goods you own, such as cash, investments, furniture, cars, a home and any other real estate. Liabilities include anything you owe to someone else, such as credit card debt, student loans, a home mortgage, etc. You can add up all your assets and subtract all your liabilities to calculate your net worth. The goal of every investor is to invest wisely to increase their net worth.

It is particularly wise to pay off any high-interest-rate debt you may have before investing, since paying off debt with a 10% interest rate is like earning a guaranteed 10% after-tax return on your investment.

After paying off any debt possible, it is important to build up an emergency cash fund that can pay at least three to six months of living expenses. This will provide you a cushion to meet any cash needs you may have in the event of a job loss, medical emergency or other difficult situation. This will provide significant peace of mind and enable you to invest any additional cash knowing that you can risk that money and still be able to meet any emergency needs that arise.

Another important step is to buy insurance appropriate to your situation, such as medical insurance (if you do not have it through your job), life insurance, disability insurance, homeowners insurance, etc. Finally, you should do estate planning, including setting up a will, healthcare and financial power of attorney, etc.

Establishing your financial goals, time horizon and risk tolerance
Once your financial house is in order, you should think about your personal financial goals, time horizon and risk tolerance. For example, do you want your investments to help you pay for a new house in five years? Or for your children’s education in 10 years? Or for your retirement in 20 years? Or are you already retired and looking for income to live on?

Setting your financial goals will help you establish your investment time horizon. Generally, if you want to try to create wealth quickly, you will generally have to accept higher risk. If you are willing to build wealth more slowly, you can usually take less risk. However, even if your immediate financial goal is buying a new house in five years, you will have financial goals beyond that, including long-term retirement. So it’s important to think about your short-term, intermediate-term and long-term time horizons when it comes to investing.

Understanding your financial goals and time horizon will help in determining how much risk you will likely need to take in order to achieve your goals. For example, if you need to generate 15% annual returns over the next five years in order to buy the house you want or 10% returns over the next 20 years to fund your retirement, then you will need to take on more investment risk than someone who is already retired and only needs 5% annual returns to live on.

But beyond the level of returns you need to reach your objectives- and therefore the level of risk you will likely need to take- each of us has a personal risk tolerance level that we can handle before investing becomes too stressful for us. For example, you should ask yourself what level of losses you can tolerate on your investments. Can you handle: 

  • losing <5% of your hard-earned investment money? If not, then you should limit yourself to very safe investments such as money market funds and short-term Treasury bills.
  • losing 5%-20%? Then you can invest in stocks and ETFs while using stop-loss orders, which we will cover later in this guide.
  • losing >20% on your investments? Then you can utilize higher-risk, higher-reward investments such as buying stocks on margin and using levered ETFs, which we will also cover later.

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