How do I know if should invest in the stock market?

While it's great that you may be taking control of your finances, the stock market is inherently risky and you can end up with some disappointing results. Industry types advise that if you can't stomach losing 20% of your portfolio overnight, then you shouldn't be investing in stocks, period. Losing that 20% on a modest $10,000 savings would mean perhaps goodbye to that new LCD TV, car insurance, or rent payment. But we'll assume you understand the risks and can stomach the roller coaster rides.

Before you invest a single cent of your money in a stock, you need a plan. Without a plan, one can run into trouble quickly and get ahead of themselves, the end result being less money in your pocket. Understanding your decisions involves looking at several key factors; your time horizon, your risk tolerance, and your inclination.

Understanding your time horizon is important since stocks can be volatile. Although stocks have consistently outperformed other asset classes (bonds, T-bills, real estate. Etc.) over any 20 year time period, over short periods the results can be catastrophic. If your time horizon is under 10 years, consider moving some money in bonds. And if you need this money within the next year, don't touch that 'buy' button, capish? While you can expect 8% on average over a 20 year period, you can't expect that in any given year and can quite often lose money for the year. In as recent as 2002, the stock market plunged 22% - eating away at well over a $2000 slice of money from your $10,000 savings.

Unfortunately for some, because stock prices fluctuate so greatly and because valuing one's portfolio takes only seconds, investors can often become emotional seeing these wide swings in portfolio values daily. While safer and more stable companies (think food producers, public utilities) provide less of that portfolio volatility, they often don't perform as well when the economy is growing rapidly. For that reason, you need to take a look at how much you want in these safer sectors, versus how much you want invested in riskier sectors like technology or mining companies.

Lastly, your knowledge of the stock market must be considered. Like many walks of life, experience is a valuable asset. The less experience you have, the riskier it will be for you to start out and invest. Many people don't have the time or inclination to provide hours per week devoted to their portfolios, so without the proper experience and devotion, picking stocks might not be the right choice. It's best to hand that task over to someone else and invest in a mutual fund or ETF in that case.

Blair is a regular reader of the stinking rich canadian blog

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