Investing for Beginners – How Much Do I Invest?

One of the hardest decisions that must be made in personal finance is when to start investing. The second hardest decision is how much to invest in the first place. Most investors when they are just starting to take their first few steps into investing and the wonderful world of compound interest are overwhelmed with the excitement and possibility of making lots of money. As the saying goes, it takes money to make money, and people are more than willing to invest more money than they should in the hopes of making high returns quickly. Although the answer to the question is different for each individual, the answer lies mainly on what your expectations are for investing and your own personality and ability to weather the risk over the long-term.

The first, and most important step to determining how much to invest is to determine the correct balance between investing and saving. For some, investing and savings are synonymous – don’t they mean the same thing? Unfortunately, this is the first mistake that needs to be corrected! Saving and investing are different concepts in personal finance: saving is money that you keep close to help hedge against the unknown and emergencies that might pop up when you least expect them. Investing is money that you use to purchase financial products to make more money but it is also money that is tied up long-term and cannot be liquidated (turned back into money) to pay for short-term costs without having to pay a fee or potentially selling an asset. 

As an example, let’s say that you have $2,000 in your bank account. You put $1,000 in the stock market and you keep $1,000 in your savings account. After a cold winter morning, your car does not start and you are forced to pay a mechanic $200 to come out and fix the issue with your car. This unexpected $200 cost would be paid from your savings account rather than your investing account. The reason for this is because your savings account currently holds cash than can easily be paid to the mechanic. If you were forced to pay the mechanic from your investing account, these would be the steps required: 1.) You would have to sell your investment – assuming that you do not have to sell at a loss which could potentially happen; 2.) You would have to take the money from the sale and transfer it to your chequing or savings account (which could potentially take anywhere from 2-5 days depending on your bank); 3.) Once the money has entered your chequing or savings account, you would be finally able to pay the mechanic for his hard work. The issue with this, other than the length of time it takes to actually access the money and potential of selling a position at a loss, is the fact that you should only be investing money that you do not require in the next 2-5 years as a longer time horizon improves the chances of making a higher return through investing.

The main point that you should grasp from the example above is that you should only start to invest once you have built up your savings. As a reminder, you should always start with an emergency fund that covers 3-6 months of your costs so that in an emergency, you have enough money to tide yourself over to your next paycheck. If you have built up an emergency fund and your savings are large enough that you feel comfortable investing, you can begin allocating a fixed part of your income towards investing and saving.

So how much do I invest? Rather than providing a specific number that may or may not take into account your current financial situation, I will provide a general rule of thumb that you may follow. For recent college grads who have created budgets and are willing to live very frugally and are currently living at home or with roommates, an extreme rule of thumb for investing would be 60% of your after-tax income which would give you 40% of your after-tax income to pay for necessities and living expenses. In this case, if you are currently making $40,000 after-tax - $3,333 a month, considering this extreme rule of thumb, you could invest up to $2,000 a month. The reality is not everyone can afford to invest 40% of their after-tax income every month and for those who are more settled and potentially have a family to take care of, the rule of thumb is to invest 30% of your after-tax income. In the same situation, assuming you are making $40,000 after-tax, you would be able to invest $1,000 a month. Please note that these are just examples and that everyone has a different financial situation and that each person’s investment amount would be different.

One thing that is very important to remember, especially when you are young and not paying off a house or paying for your children’s education, the more money you invest today, the faster that it will grow and will help you reach your financial objectives. With most things in life, the opportunity cost of not investing every dollar you can is the loss of purchasing power through inflation in the future.

So, what is the lesson? The lesson is simple: the best thing you can do for future you is to build up an emergency fund as early as you can and then to begin investing no matter how small the amount! You will not become rich quickly, but you will build wealth gradually and your future self will thank you!

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