The investment order of operations refers to the optimal sequence of steps that investors should follow to build long-term wealth. Getting the order right allows investors to maximize returns while minimizing risks and taxes. This involves prioritizing high-return investments, taking advantage of tax-advantaged accounts, balancing portfolio risk, automating deposits, avoiding unnecessary fees and more. By following the proper investment order of operations, individuals can put their savings to work in the most efficient way possible.
The key elements of the investment order of operations include establishing an emergency fund, contributing to retirement accounts, paying down high-interest debt, investing in taxable accounts and more. While the specifics can vary based on each investor’s unique situation, the overarching principles remain constant. Adhering to these principles and fine-tuning the details to match one’s own circumstances is crucial for investment success.
Build emergency savings
The first step in the investment order of operations is establishing a rainy day fund with 3-6 months of living expenses. This emergency savings provides a buffer against unexpected costs like medical bills or car repairs. It also prevents investors from needing to sell assets or go into debt to cover urgent costs. An emergency fund should be held in a safe, liquid account like a savings account. The peace of mind and financial flexibility offered by emergency savings is well worth the small opportunity cost of holding cash versus higher-return investments.
Pay down high interest debt
The next priority is eliminating any high-interest debt like credit cards or payday loans. Interest rates on these debts often exceed 15-30%, making them extremely expensive. Paying off high-interest debt provides a guaranteed return equal to the interest rate. This risk-free return will almost always exceed returns possible in the financial markets. Paying off 19% credit card debt for example provides the equivalent of a 19% return on investment. Debt repayment should take priority over any investing until high-interest debts are eliminated.
Obtain employer retirement match
For those lucky enough to have an employer-sponsored retirement plan like a 401(k) with a matching contribution, obtaining the full match should be the next investment priority. A 50% match on contributions up to 6% of salary for example equates to a guaranteed 50% return on that portion of savings. This risk-free return is hard to beat even with the best investing strategy. Investors should contribute at least enough to their retirement plan to obtain the full employer match before directing additional funds elsewhere.
Max out tax-advantaged accounts
Once high-interest debt is paid off, the next step is to fully fund all available tax-advantaged retirement accounts like 401(k)s, IRAs, HSAs and more. Contributions to these accounts either reduce taxable income today via deductions or allow tax-deferred growth on gains and dividends. Making maximum allowable contributions reduces investors’ annual tax bills while accelerating the growth of their nest egg. For 2023, the combined contribution limits on 401(k)s and IRAs equals $27,000 for those under 50 and $35,000 for those 50 and older.
Invest for major goals 5+ years out
With an emergency fund established, expensive debts eliminated and tax-advantaged accounts maxed out, investors can then direct funds towards other medium-term goals like saving for a house, car, education, etc. Investing for major goals 5-10 years in the future allows time for assets to appreciate while minimizing liquidity needs. A total stock market index fund or target date fund may be appropriate for goals more than 5 years out. Keeping some dry powder in cash is wise for nearer-term objectives.
Following the proper investment order of operations allows individuals to maximize returns on their savings in a tax-efficient manner while maintaining financial security. This involves prioritizing emergency savings, debt repayment, employer matches, tax-advantaged accounts and more before investing in taxable accounts. Fine-tuning the details to match one’s specific circumstances accelerates wealth-building.