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How Much Can You Afford to Invest in the Stock Market?

Whether you already own stocks or are looking to get into the stock market, you need to find out about how much money you can afford to invest. No matter what you hope to accomplish with your stock investing plan, the first step you should take is to figure out how much you own and how much you owe.

To do this, prepare and review your personal balance sheet. A balance sheet is simply a list of your assets, your liabilities, and what each item is currently worth so you can arrive at your net worth. Your net worth is total assets minus total liabilities.

Composing your balance sheet is simple. Pull out a pencil and a piece of paper. For the computer savvy, a spreadsheet software program accomplishes the same task. Gather all your financial documents, such as bank and brokerage statements and other such paperwork — you need figures from these documents. Update your balance sheet at least once a year to monitor your financial progress (is your net worth going up or down?).

Step 1: Make sure you have an emergency fund

First, list cash on your balance sheet. Your goal is to have a reserve of at least three to six months’ worth of your gross living expenses in cash and cash equivalents. The cash is important because it gives you a cushion. Three to six months’ worth is usually enough to get you through the most common forms of financial disruption, such as losing your job.

If your monthly expenses (or outgo) are $2,000, you should have at least $6,000, and probably closer to $12,000, in a secure, FDIC-insured, interest-bearing bank account (or another relatively safe, interest-bearing vehicle such as a money market fund). Consider this account an emergency fund, not an investment. Don’t use this money to buy stocks.

Resist the urge to start thinking of your investment in stocks as a savings account generating more than 20 percent per year. This is dangerous thinking! If your investments tank, or if you lose your job, you’ll have financial difficulty and that will affect your stock portfolio (you may have to sell some stocks in your account just to get money to pay the bills). An emergency fund helps you through a temporary cash crunch.

Step 2: Tally up your income

List and calculate the money you have coming in. The first column describes the source of the money, the second column indicates the monthly amount from each respective source, and the last column indicates the amount projected for a full year. Include all income, such as wages, business income, dividends, interest income, and so on.

Item Monthly $ Amount Yearly $ Amount
Salary and wages
Interest income and dividends
Business net (after taxes) income
Other income
Total income

Step 3: Add up your outgo

List and calculate the money that’s going out. The first column describes the source of the expense, the second column indicates the monthly amount, and the third column shows the amount projected for a full year.

Item Monthly $ Amount Yearly $ Amount
Payroll taxes
Rent or mortgage
Utilities
Food
Clothing
Insurance (medical, auto, homeowners, and so on)
Telephone
Real estate taxes
Auto expenses
Charity
Recreation
Credit card payments
Loan payments
Other
Total outgo

You may notice that the outgo doesn’t include items such as payments to a 401(k) plan and other savings vehicles. They’re not expenses; the amounts that you invest (or your employer invests for you) are essentially assets that benefit your financial situation versus expenses that don’t help you build wealth. To account for the 401(k), simply deduct it from the gross pay before you calculate the preceding worksheet.

Step 4: Create a cash flow statement

The next step is creating a cash flow statement so that you can see how much comes in and how much goes out and where it goes.

Plug the amount of your total income and the amount of your total expenses into the worksheet below to see your cash flow. Do you have positive cash flow so that you can start investing in stocks (or other investments), or are expenses overpowering your income?

Doing a cash flow statement isn’t just about finding money in your financial situation to fund your stock program. First and foremost, it’s about your financial well-being. Are you managing your finances well or not?

Item Monthly $ Amount Yearly $ Amount
Total income
Total outgo
Net inflow/outflow

Step 5: Analyze your cash flow

Use your cash flow statement to identify sources of funds for your investment program. The more you can increase your income and decrease your outgo, the better. Scrutinize your data. Where can you improve the results? Here are some questions to ask yourself:

  • How can you increase your income? Do you have hobbies, interests, or skills that can generate extra cash for you?

  • Can you get more paid overtime at work? How about a promotion or a job change?

  • Where can you cut expenses?

  • Have you categorized your expenses as either “necessary” or “nonessential”?

  • Can you lower your debt payments by refinancing or consolidating loans and credit card balances?

  • Have you shopped around for lower insurance or telephone rates?

  • Have you analyzed your tax withholdings in your paycheck to make sure that you’re not overpaying your taxes (just to get your overpayment back next year as a refund)?

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