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When generating wealth, stocks are often the first place many look. However, a question posed by many is: how much of your income should be allocated to stocks? In this article, we’ll aim to answer this question, exploring the factors influencing this decision and providing actionable guidelines to help tailor your stock investment strategy.
Before we dive into this question, there’s a crucial aspect to discuss: personal finance. While the allure of stock gains is powerful, many recommend having a solid financial foundation before taking the plunge.
First is an emergency fund. Aiming for 3-6 months of monthly expenses stashed in a savings account is a good idea. This means you won’t need to cash in your stocks, potentially at a loss, when you urgently need to pay an unexpected bill, for example.
Next, debt with high-interest rates, especially credit card debt, can erode your investment returns. Many advise clearing these before making a heavy investment in the stock market. Note that while it is a good idea to reduce your high-interest debt, long-term, low-interest debt like student loans or mortgages may not require the same urgency—it depends on the context.
Lastly, consider insurance, whether for health, life, or disability. Insurance can shield you against unforeseen calamities, preventing major setbacks in your long-term investment journey.
With personal finance covered, the next step is evaluating your financial goals and risk tolerance.
Are you saving to buy a house, building up retirement savings, or aiming to generate enough money for your dream holiday? Whether your goals are short-term or long-term can be a significant factor in your overall investment plan.
If you are happy with steady returns that simply outpace inflation, you might invest more conservatively. On the other hand, if you are aiming for higher returns in a short space of time, then you’ll normally be required to assume more risk and deal with greater volatility.
Your ability to stomach market volatility is more formally known as your risk tolerance. Risk tolerance is determined by many factors out of our immediate control, including age, financial situation, and prior investment experience.
For instance, younger individuals often take more risks with their investment portfolios since they have a longer time horizon, enabling them to recover from downturns. Meanwhile, being financially stable can offer a buffer against losses but may also encourage the preservation of wealth.
At the end of the day, only you can determine your investing goals and risk tolerance. If you are unsure of the latter, there are many risk tolerance quizzes available online that can help.
So how much of your income should you allocate to your investment account? A popular guideline is the 50/30/20 rule. This rule of thumb says that 50% of your post-tax income should be for essentials, 30% for discretionary spending, and 20% towards a savings plan and investments.
Within the 20%, the exact percentage allocated to stocks is up to you. Depending on your circumstances, you could keep it at 10% for simplicity or adjust it to a 15/5% stocks/savings split.
For some, this allocation can be performed automatically through a company retirement plan, which deducts a set amount from your paycheck each month. These plans may be tax-advantaged and employer-matched, helping you to save more for retirement.
For others, many fintech and robo-advisor platforms can automatically withdraw and invest your money on payday. This can be especially useful for remaining disciplined in your investment strategy.
Diversification is often likened to not putting all your eggs in one basket. In investment terms, it's a strategy to spread your money across various assets, ensuring that a dip in one sector doesn't devastate your entire portfolio. Instead of banking on one or two individual stocks, you might invest in several industries, regions, and trends.
Investment options here are myriad. You might opt for a mix of growth and value stocks or allocate a large percentage to stable index funds and the rest to riskier plays. There are also exchange-traded funds (ETFs) and mutual funds that track the performance of broad markets or specific sectors, offering diversification with a single purchase.
Beyond stocks, consider integrating bonds, commodities, real estate, and even emerging market investments into your portfolio. Each asset class responds differently to market events and can help smoothen the inevitable ups and downs in your brokerage account.
Like many of the best things in life, investing takes work. As life progresses, personal circumstances, financial goals, and market conditions can change. For that reason, periodically reevaluating your portfolio is key.
A particular stock might’ve outperformed, causing an imbalance in your preferred asset allocation. Maybe your financial planning has changed due to life changes, like marriage, children, or a career shift. Or perhaps an economic downturn has made you want to up your savings goals and decrease your regular investments.
Whatever it is, regular check-ins, whether quarterly, semi-annually, or annually, can allow you to rebalance your portfolio and make sure it aligns with your current risk tolerance and objectives. However, remember to keep a long-term perspective. As the saying goes, ‘time in the market is more important than timing the market’.
While taking the first steps in financial markets may seem daunting, anchoring your investment decisions to a strong foundation of personal finance, clear goals, and defined risk tolerance can make the process much easier. The 50/30/20 rule of thumb given here is a good place to start, but ultimately, the process is unique for everyone, and there’s no one-size-fits-all approach.
With FP Markets, you can trade (invest) in a wide selection of global asset classes through CFDs (Contracts for Differences), such as Forex, Shares, Indices, Commodities, Bonds, Digital Currencies and ETFs.
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