Living below your means
Perhaps the most important idea underlying any sound approach to investing is recognizing that you need to save a significant portion of income every month to have enough money for funding financial goals. Common goals include home purchases, higher education for dependents, and retirement.
There is no substitute for spending less than you earn. If you don’t save enough, no amount of financial trickery will provide the returns needed for a comfortable retirement.
Develop a budget
The first step towards developing a workable financial plan is to adhere to a sensible household budget – one that provides for needed expenditures, discretionary pleasures, savings for big-ticket items, and savings for long-term retirement planning.
Avoid or cut excess debt
To keep control over expenses it is best to avoid excess debt, such as revolving credit card debt and home equity loans. If you have such debt, pay off those balances first.
Reducing expenses and unneeded debt can allow you to consistently set aside a portion of earnings for decades. For some guidance on how much to save, refer to this table derived from research provided by Dr. Wade Pfau, in his article Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle, Journal of Financial Planning, May 2011.
The table below shows the importance of saving early (the subject of our next installment on investment principles). For example, your retirement portfolio consists of a 60/40 (stocks / bonds) allocation. You will be spending 50% of your current income in retirement and plan to save for retirement over 30 years.
According to the table, you will need to save 16.62% of your income to retire. If you had started saving for retirement 10 years earlier (40 years of savings), you would only need to save 8.77% of your income.
Develop an investing plan
Next, after establishing a sound financial lifestyle and you start investing for the future, many believe it is valuable to put a simple investment plan in writing.
Invest money you’ll need soon very conservatively, like in a MoneyMarket or a Bank CD; definitely not the stock market. This is due to the fact that stocks are too volatile for funding short-term obligations.
Money you need beyond 10 years can be invested in a portfolio of stocks and bonds.
Putting your plan in writing will help give you the discipline to “stay the course”.
Next post in the investing basics series: The advantages of investing early and often.