Don't Ask This Investing Question First

Years ago, when I was still working as a graphic designer I came into some money because of an unexpected layoff. With no better idea, I deposited it into a savings account and let it sit there for two years as I agonized in indecision over what to do with it.

My first thought was to consult with my brother-in-law who had been to business school, and was applying for jobs with hedge funds. He drove a Porsche, liked to talk about tech stocks, and appeared to be an expert in money. I thought he'd have the perfect hot tip for me, but I was afraid to ask because I felt so stupid that I didn’t know the difference between a stock and a bond. I stayed quiet and let my money continue to stew in savings. (For more, see: Setting Financial Goals for Your Future.)

Instead of someone with stock picks, I should have been looking for an expert in my personal goals. Someone who knew exactly what I wanted in life and when I wanted to achieve it. And of course the only person with that insight was me.

If I had gone up to my brother-in-law at Thanksgiving and asked, “How should I invest the few thousand dollars I have sitting in my savings account?” he would likely have said, “Buy stock in Network Widgets - it's on a tear right now!” (FYI, Network Widgets is made up). I probably would have done it. But here's why that's the wrong first question to ask.

Whether or not Network Widgets was a good stock to own in 2001 is beside the point. Instead of asking for a semi-informed, tech stock dart-toss, what I really needed was the guidance to step back and look at the big picture. And from where I sit now as a Certified Financial Planner (CFP) professional, these are the steps I should have taken.

Step 1: Are You Ready?

Before diving into the world of investing it's important to evaluate if you're ready to support your fledgling investments once they are made. For my money, there are two important pieces I always make sure to have in place:

• Eliminate any high interest credit card debt. Any gains made from investments would likely pale in comparison to the interest you pay to maintain credit card debt over the long term, so paying them off first could be your most productive, no risk investment.
• Establish an emergency cash reserve. Cash in a savings account, while not growing in value, will act as an important buffer around your investments - protecting them from untimely withdrawals if you find yourself with an unforeseen cash shortfall. I recommend shooting for between three and six months of living expenses.

Step 2: Assign It a Job

Once you've confirmed that you’re ready, you needed to give your investment money a job to do. Will it fund retirement, a career change, a vacation? Attaching your money to a specific goal will allow you to set a timeline, which will inform your risk tolerance - the measure of how much uncertainty and volatility can you handle with your investments. (For more, see: Why You Absolutely Need an Emergency Fund.)

When it comes to the stock and bond markets, uncertainty is the name of the game, but exposing your dollars to risk also means exposing them to growth potential. The more time you have, say 25 years before retirement, the better you can weather the day-to-day ups and downs of the market, allowing you to more confidently embrace risk. In contrast, if you'll need your money within a few months or even a few years, an unexpected market downturn could get in the way of reaching your goals, and you'd be wise to turn down the risk, placing your investments in safer bonds and cash.

My goal is to always balance risk and time so that your money can work as productively as possible, without taking unnecessary chances.

Step 3: Get in Touch With Your Emotions

The other part of estimating your risk tolerance is knowing what you can and can't stomach emotionally when it comes to uncertainty. The stock and bond markets are inherently volatile, and if experiencing that volatility keeps you up at night - potentially inspiring you to make emotional decisions with your investments - then you should consider looking for lower risk places to put your money. Otherwise, you'll be in danger of reacting to short-term news and selling at the bottom of down-market moment.

The field of behavioral finance pairs psychology and economics, and has emerged to explain the irrational actions taken by human beings in regard to their investments. Long story short: PhDs and Nobel laureates have concluded that emotional risk tolerance cannot be ignored - even if it means lowering your expected return.

To Sum Up

Looking for stock tips from a Porsche-driving relative doesn't go deep enough. Instead you'll want to spend the time to understand your:

• Current situation
• Goals
• Timeline
• Risk tolerance

Combine these four elements and you’ll have created a well-balanced investment policy statement, which will act as a compass for your investment dollars, taking much of the agony out of the question, ‘What should I invest in?’

And what did I do with my savings? I used it to go back to school and make a career change - one of the best investments I've ever made and something that is still going up in value. (For more, see: What Is Your Risk Tolerance?)

A version of this article first appeared on https://www.insightpersonalfinance.com/.