For many, investing seems to happen in a foreign place where the inhabitants speak a strange language. Most don’t know where to begin, and it’s easy to understand why: They don’t teach this stuff in school. One thing, however, is clear. Unless you entered life with a trust fund, investing starts with small savings and the cultivation of the savings habit. So let’s start at the beginning, with techniques for saving and how to plan your investment scheme.
Developing the Saving Habit
Too many of us procrastinate. It’s easy to convince yourself that setting aside only a few dollars will make little difference compared to some “urgent” household or personal need. While sometimes these needs can be genuinely important, most are usually an excuse to put off saving and seek immediate gratification instead. It might help you resist temptation to realize that every dollar you save each week or even each month will start growing beyond what you are depositing, what I call building on itself. And soon the increased savings will offer their own gratifications. The effort will also help you strengthen your saving habit, which, in most cases, is more than half the battle.
Here are seven tips to get in the habit of saving:
- Put aside all your loose change in a jar at the end of the day. Better yet, add a dollar or five dollars into the jar each evening. Such small amounts can quickly become a significant contribution to your savings. And most of the time it’s money that you won’t miss.
- Leave your credit cards at home. Paying with cash will put a cap on how much you spend at a given time. And if you have to run home to get the card, it might give you time to rethink an unnecessary expenditure.
- Contribute to stock purchase plans and reinvest the dividends. Many companies allow employees to use part of their paychecks to buy the firm’s stock through automatic deductions. This is money you might otherwise spend. If you are in such a program, reinvest the dividends instead of taking them in cash. This is a good rule to follow with any stock you own.
- Consider savings as you would any regular expense — like bills from the electric company or mortgage payments. Set a dollar amount, say 1 percent of your take-home pay, or better yet 5 percent if you can, and “pay” that into your savings account each paycheck.
- Use automatic savings plans. Some employers offer plans that take a designated amount of your paycheck to buy you U.S. government savings bonds (more on these in later posts). Ask your bank if it can automatically transfer a designated amount each month from your checking to your savings account.
- Keep putting money aside even after you have paid off a loan or a mortgage. Continue to write a check every month for the same amount, or at least a good portion of it, and put it into your savings. This is money that you have long learned to live without, so you can increase your wealth painlessly.
- Occasionally give yourself a reward. Saving is hard, and its payoff is often years in the future. So once or twice a year, designate one month’s set aside for a little extra spending. Take the family out to dinner or buy something special for yourself or someone you love. It will give you something to look forward to that is nearer in time than the ultimate use of your savings.
Make a Plan
Though saving and investment plans vary as much as individual desires and goals, one element should appear in every plan: an emergency fund, a pool of cash for unforeseen events, like sudden medical problems, appliance repairs, or possible unemployment. Ideally, set aside 3 to 6 months income to cover such needs. The money should go into what financial people call a “liquid vehicle,” one that you can access immediately such as a bank savings account or other easily accessible vehicles that I will describe in subsequent posts. Once in place, this saved money will work for you: by building on itself through bank interest and by protecting you and your loved ones from harm. Importantly, it will also give you confidence to take the next steps.
Once you have established this basic source of security, and the habit of saving, you can begin focusing on personal wants and needs. There is no right answer here. Much depends on your age, income, family circumstances, and interests. The money should serve your desires as well as your needs. Some goals are very long term, like a young person saving for retirement. Others are not quite that far off, like college for a newborn or buying a home, or starting a new business. Still others may be more immediate, like buying a new car or kitchen. All are legitimate, but each requires a different investment strategy.
To organize your thinking, create a small chart like the one at the end of this section. It can link each need to an investment goal. List your savings goals on the left. I offer a few examples. Yours will be different. Next, fill in the likely cost. You can research this on the Internet but in the case of housing for example, you may also want to do a bit more research about what it will cost when you are ready to buy. Next, determine when you expect to need the money. Count the months to that date and divide the cost by the number of months to see how much you’ll have to put aside each month.
The “months to go” will reflect where you are in your financial life. A parent starting a college fund for a newborn, will be looking at an 18-year time horizon (216 months) before he or she needs the money. Other goals will reflect more personal preferences. If you think your car will last only another year, you’ll have to save for the replacement in only twelve months. Plans to marry in two years will give you 24 months to accumulate the desired funds. If planning reveals that your goal requires more savings a month than you can support, you might have to adjust your lifestyle, delay the target date, or even abandon this particular goal. Harsh as these tradeoffs may seem, they are simply facts of life that no one can ignore.
|Goal||Cost||Date||Months to Go||Set Aside Each Month|
|Purchase of Home Entertainment System:|
|Money for a Good Vacation:|
|Funds to Buy a New Kitchen:|
|Purchase of a Home:|
|Money for a Retirement Nest Egg:||
Executing the Plan — Time is on Your Side
The further in the future your target date is, the less harsh the tradeoffs. Remember that everything you save earns interest or dividends that over time will build the fund alongside your monthly savings contributions. Because you are paid this interest not only on your contributions but also on the interest previously accumulated, what financial people call compounding, the longer you can wait before using the money, the more your savings or investment plan will help you accumulate. These earnings will defray the burden of the monthly set aside. Two examples:
One: You need $20,000 for a car and a year to get the money. Here, returns from investments will contribute only a small part of the total. In this example, it will require a set aside of about $1,629 a month. Even if the savings account pays 5 percent, it would earn only about $88 over the course of the year. So most of the money would have to come from your monthly savings contributions.
Two: With longer-term projects, however, earnings from savings and investments can contribute considerably more. Say you are one of a newly married couple that wants to buy a $250,000 home in 15 years. To meet your goal entirely from setting money aside, you would have to save $1,389 a month. But after five years of saving at that rate, your accumulated investment account would amount to $83,333. At 5 percent interest, it would earn $4,723 a year from then on and more each successive year from the accumulated interest as well as your contributions. That income alone would effectively substitute for over three months of future savings every year. After ten years, you would have accumulated $166,666. At a 5 percent interest return, it would earn $10,784 a year, enough to pay over seven months’ required savings. These would amount to a major contribution toward your goal of home ownership. This is why time is on your side. The table at the end of this post lays out the accumulations of savings and interest year by year.
With even longer time horizons — say retirement savings — the contribution from investment income becomes even more significant. Over 30 years, in fact, the accumulated earnings from the investments would actually exceed the total of monthly set-asides. In the example of the home purchase, the annual earnings from accumulated savings already by the fifteenth year would have come close to surpassing the annual savings need originally calculated.
Interest Earnings Help Savings Accumulate