In the course of wealth building, many people like to make things easier by paying themselves first, setting aside x amount of money to invest and save. This amount will not be touched for daily necessities and other uses.
Paying themselves first is of course a great personal finance tip, and one I will advocate as well.
For the singles or those that saw the light of how early savings and investments can prove to be fruitful in the future (read the power of compounding early), they tend to save 50-60% of their disposable income.
This amount they will use it as their “bullets” to build wealth by investing at a higher rate, through stocks and bonds, properties.
To a certain extent I think we can improve upon this and be more goal focus when it comes to wealth accumulation.
Different Goals, Different Time Frames
The pool of savings and investments are meant to meet certain needs. Often times, it is not just for retirement.
It is likely at different time periods you will need the money.
Many of the goals happen to be congested to when you are in your late 20s and early 30s and you will need the money pretty fast.
Mixing it up as a lump sum, doesn’t provide you with the clarity whether you have saved up enough for the objective.
As a lump sum, drawing it down may result in you having a shortfall in another objective, which is maybe something you do not want.
Giving your money a job individually may have been more ideal.
To build wealth, you have different instruments and they have varied return rates.
As risk and reward are proportional, diverting a large part of your lump sum savings to stocks and commodities may result in high potential returns.
However, stocks and commodities have shown to suffer from large volatilities in the short term. In 2009 equities went down by 50-70%.
Think of what you would do if you suddenly have a smaller pool of money to work with to fund your housing down payment, saving for a car. You may need to forgo your masters program or delay it.
Splitting your savings up isolates portfolios based on the objectives and allows you to know the kind of volatility they can suffer least from.
Your retirement and children’s university saving can probably take more fluctuation. Having stocks and commodities might be ok.
If you need money within 5 years, a large level of predictability may be required.
How to divide up your savings
Here at Investment Moats, we have talked about budgeting using virtual envelopes.
To divide your savings based on different objectives, create individual virtual envelopes for it.
In the case of a person earning $4000, his take home pay after government forced savings will be $3200.
His intention for saving 50% of his take home pay can be broken up to
- Building up a freedom fund: $700
- Saving up for children’s university education: $300
- Saving up to downplay a car ($30,000) :$500
- Emergency fund:$100
This gives you a good visualization of high objective is more important.
So if this person gets unemployed tomorrow, he may have to scale down his savings.
He can have the choice to not save for his car down payment. This will seriously impact his goal near term. He could probably restart saving after getting another job.
Or he could scale down his retirement savings. This looks an unwise move but if he is not able to survive now, why save for the future?
If he goes down that route it is likely he will have to save doubly hard to ensure he does not miss his retirement target.
The end state is, objectives are clear, the person knows how much he can drawdown for each objective and if he has to use another account he will have to bear with the consequences.