Jan

27

A Basic Savings and Investment Strategy: 10/10/10

January 27, 2007 |

Most people want to save money and invest it so that they can secure their life and make sure it becomes even more enjoyable over time. The main issue most people have is a lack of strategy. A savings-wish with no strategy doesn’t become a solid, attainable goal. In this article you will find a good Savings and Investment Strategy and suggested investment vehicles for the beginning investor. It should be an easy strategy to implement for most income levels. Yet, it only contains a handful of accounts that simplifies management even for the most affluent.

The strategy is supported by two things: (1) a Pay Yourself First approach, where you deposit your investment money as soon as you receive it, before even paying other bills, and (2) It is organized in accounts by purpose and time frame. It is a strategy that does requires 30% of your salary (before taxes and deductions) to be dedicated towards your financial safety (but don’t worry, generally speaking, a third of such money will be spent on luxury).

I believe life throws at us three types of Economic Challenges:

  • Short Term and Emergency: This is the fun part. This is where you will feel rich now (or close to now), and this is what will bring you peace of mind at night. If anything, this is the first priority you should fund: because this is the one that will prevent you from falling into credit card debt. Save 10% in liquid accounts for emergencies, vacations, computers, cars, and other expenses that people usually charge up into medium term credit.
    Your first priority should be to have enough savings to cover a few months of take-home salary (3 months could be a reasonable goal). But once you accomplish that, all of the remaining money in this account will be devoted to pure fun. Splurges of luxury, if you want to call them like that. The vacations you enjoy, or the big screen tv you want to watch. It is the ability to live richly within your means.
  • Retirement: Make sure your silver and golden years are taken care of first. You do not want to work until your last day of your life. 10% of pre-tax income or more goes into IRAs, 401ks or other retirement vehicles. Maximize them whenever possible, as the sooner you fund them, the longer they have to grow, tax sheltered.
  • Long Term: These are the goals that will make you feel proud of yourself and what you have accomplished. Save and Invest 10% in taxable accounts for goals like purchasing a house, higher education (yours, spouse, or child), financial freedom, or early retirement.

Some people are initially surprised by the 30% number. They shouldn’t. It is not as much as people think. The Short Term money is money spent regularly, but instead of paying it after you buy to a credit card, you will have the money ready at the time you buy. The money that goes into Retirement accounts is most probably sheltered in some way from income taxes, so the impact into your pocket money is reduced. And the money for your proudest achievements that go into the Long Term savings is money you would have had to make available anyway — that is, if you want to do things that make you feel proud. However, I do understand it is a significant change in the financial behavior for some people, and via this blog I try to suggest ways to make it as simple and efficient as possible.

If you are not saving 30% of your income already, then do it step by step. May I suggest:

  1. Short Term Savings: Start by setting up a savings account or money market account. Your local bank is fine, and it is not important to optimize the interest rate you get on it. Save 10% of your income there, as soon as you get your paycheck. Most banks will allow you to make the transfers automatic — do so, it will work better that way. As soon as you save a month’s worth of take-home pay (minus savings), move that money into a 3 month, self-renewing Certificate of Deposit. These are not investments, these are emergency savings. Keep saving until you can build a 3 month CD Ladder. Once you have your ladder, all the rest of the money you save into this account is to have fun. My brother calls his short term Savings Account his “Fun Account”. I call my short term Money Market Account my “Discretionary Account”.
  2. Retirement: Once you are able to put 10% of your money towards Short Term Savings, it is time to also work towards 10% in your retirement accounts. Invest money through your employer’s sponsored 401k or SIMPLE-IRA. If your employer doesn’t have such plans (or similar), open an IRA. Put 10%. If you don’t feel ready to put 10%, put 5%, and increase it as time goes on. Some people debate what instrument is better, 401k, IRA, Roth IRA, or others. My advice is that if it is sponsored by your employer, use that instrument as your primary instrument: it is the one that requires less effort on your part, and for most people, less effort means higher chance of achieving their goals. You may want to check into an article with suggestions on how to allocate the money invested into a retirement account.
  3. Long Term Investments: Once you fund your current life (something not everybody does), and you are on your way to funding your Retirement, you can fund your great achievements. I put it last in your list of things to achieve because you can always buy a house later, but you should not be risking going into debt by not having emergency savings or the money to buy your luxuries, and you should not risk poverty on the years you are least able to produce money. This is money you will not probably use in the next couple of years, and as such you can invest it. A Mutual Fund, Electronic Traded Fund, or Brokerage account could be a good idea. Those with kids may want to think about Educational IRAs or 529 plans. Again, make the transfers automatic so that it requires less discipline on your part and that makes the goal more achievable. You may want to check into the Frugal Stock Market Choices for investment vehicles that may be appropriate for this kind of savings.

Is 10%/10%/10% enough? I believe it is a reasonable amount that will allow you to enjoy life and build a strong economic foundation for you and your family. Some people choose to save and invest even more — more power to them. If you are in such position in which you can invest more than what I suggest, you are probably beyond the need for a Basic Investment Strategy.

Implementing this strategy may take you a few months, maybe even a few years. That is fine as long as every month that goes by you are closer to the goal of allocating 10%/10%/10% of your salary to your economic security and growth.


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