31 Days to Financial Independence (Day 25): Investing and Saving for Other Goals

“31 Days to Financial Independence” is an ongoing series that appears every Thursday on The Simple Dollar. You might want to start this series from the beginning!

Last time, we took a look at saving and investing for educational needs, which pairs up nicely with our earlier look at saving for retirement. Retirement and college savings are two of the biggest goals that people have in terms of saving and investing for the future.

But they’re far from the only goals.

People save money for lots of reasons. They save for a down payment for a house. They save for a down payment for a car – or to buy a car entirely in cash – because those moves will save a ton on interest for a car loan. They save to go on a really nice vacation. They save up to launch a side project or a small business.

Typically, savings goals outside of retirement and education tend to be smaller goals – $100,000 or less, though still pretty large for most Americans. They tend to have a shorter term focus, meaning that the intent is to use the savings in the next few years. Also, there is rarely any sort of tax-advantaged opportunities for saving or investing for those goals.

Because of those differences, you need to use some different approaches for saving for smaller goals than you need to use for the big retirement and education goals. Let’s take a look at those approaches.

First and foremost, you need to establish an approximate timeframe for your goal. When exactly do you intend to buy a new car? When do you intend to move forward with that house purchase? When do you plan on going on that vacation to Norway?

You don’t need to be perfect here. You merely need to figure out a good rough ballpark estimate so that you have some basis upon which to make decisions about how to best save for and achieve that goal.

Setting a target date for your goal helps you to articulate not only how you will invest for that goal, but also the rate at which you need to save for that goal.

There’s another piece of the equation you’ll need, too.

You also need to establish an approximate dollar target for your goal. How much of a down payment will you need for that house? How much will that trip to Norway actually cost you? How much will that van purchase you’re considering actually set you back?

This will take a bit of research, of course, but without it, it’s basically impossible to put a real savings plan in place. You need to know how much you’re saving. The reason? Along with the timeline, you can use those numbers to figure out exactly how much you need to save each month.

Let’s say, for example, that you’re planning on traveling with your spouse and three children to London during the summer of 2019 for a week, which will include a day trip to Paris. (I’m just using this as *ahem* an example.) Your budget for that trip is $12,000. Between now and then, you have 30 months to save. Because you have both a budget and a timeline, you can quickly divide the two numbers and discover that you need to save $400 a month to be able to pay for the trip in cash.

Or, let’s say you’ve decided to buy a home in three years and you need a $50,000 down payment. You have 36 months to save for it, so you need to put away about $1,400 a month to get there.

There’s another reason why having a timeframe and a dollar amount is useful, too.

Your timeframe dictates where you should put your money while saving up. Let’s talk a little about Investing 101 here. When you choose to put your money somewhere for the future, the method you use to store that money needs to be in alignment with your goals.

To keep things as simple as possible, let’s talk about investments in terms of risk and reward. Most people recognize that the higher the risk of an investment, the higher the potential reward. One very common way this plays out with investments is in the form of volatility. A volatile investment is one that varies widely from year to year in terms of the returns you earn from it.

Typically, with most mainstream investments, what you really get is a higher average annual return in exchange for higher volatility. It’s a particular flavor of that risk-reward balance.

Let’s look at a regular bank account first. A bank account has extremely low volatility. It’s virtually certain to hold its value and slowly earn interest at whatever rate the bank offers, right? The catch is that the rate of return is really low, too. You only earn 1%, but you’re earning that 1% consistently and you have essentially no risk of losing your balance.

On the other side of that coin, let’s look at a stock market investment. One typical way that people invest in the stock market is via an index fund like the Vanguard Total Stock Market Index. They open an account with Vanguard, buy shares of that fund, and just sit on it. The Vanguard Total Stock Market Index basically owns shares in everything in the stock market, and thus when you buy a share in that index, you’re effectively buying a tiny, tiny fraction of a share in every single publicly traded company in the United States. What that means is that when you hear about the “stock market” going up or down on the news, that’s almost exactly what the Vanguard Total Stock Market Index is doing. You’re basically investing in the “stock market” as a whole.

An investment like that is way more volatile. Over the course of a lot of years, the return settles down to an average of somewhere around 7% to 10% depending on how you calculate it, but that average comes with a ton of volatility. That 7% average over a decade might include years with a 16% return and a 21% return and another year with a 41% loss.

The problem with that is that in order to get that 7% average, you have to be invested for a while. It’s usually suggested that you be invested for a decade or more at least. If you invest for fewer years than that, things can go bad. Very bad.

Let’s say, for example, that the stock market had a ten year run that looked like this: 11.74%, 1.38%, 13.52%, 32.15%, 15.89%, 2.10%, 14.82%, 25.94%, -36.55%, and 5.48%. In seven out of those ten years, you’re going to be doing better in the stock market than in a savings account; in two more of those years, you’re roughly matching a savings account. The tenth year is a complete disaster.

What if you’re invested for three years? Given that stretch of numbers above – which, incidentally, is the annual return of the S&P 500 index for the last decade – most of the three year averages are pretty good… except for the three that include that disastrous -36.55% year, in which you’re still likely losing money.

It’s only when you include most of or all of those years that you have a consistent average that’s higher than what you’d get from a savings account. If you invest only for a small number of years, you might have a really good return… or you might lose a significant portion of your investment, and with fewer years, it gets more and more risky.

Thus, the best strategy for a short term investment, particularly with a timeline under ten years, is to put it somewhere safe and secure. This becomes more and more true the shorter your timeline is.

So, what do you do?

Exercise #25 – Building a Plan for Saving for Other Goals and Executing It

The first step is to figure out exactly what you’re saving for. You probably have a goal in mind, but if you’re going to achieve that goal, you need to pin it down a little more firmly, and that means making some plans.

First of all, what exactly is your goal? You need to make it as specific as you can so that you can come up with some realistic numbers upon which to base your plans. Do some homework on whatever your goal is and get a grasp on how much you’re going to need to have to make it a reality. This may involve making a preliminary budget. At the same time, settle on a timeline for your goal. Know when you’re going to do it.

The purpose here is to make your goal as clear as possible so that you can turn it into a statement of “I need to have X dollars in Y months.” You need to do the thinking and planning in your own life for your own situation to figure out what X and Y are for your own particular goal.

Once you’ve figured out the amount and the timeline, make an investment decision based upon the time until you need the money.

If it’s less than five years, I wouldn’t consider anything other than a very low-risk low-reward investment, like a combination of a savings account or money market account and certificates of deposit. You can shop around various banks for the best rate, but you want that in a steady and secure FDIC insured bank account.

If the timeline is substantially more than ten years, such that you’ll have a healthy portion of your savings already in place when you still have ten years left to go, I’d consider the stock market in the form of an index fund, as described above.

If your timeline is somewhere in between, you can consider a mix of options, but I’d still lean toward something very secure, like a savings account and certificates of deposit at the bank.

What about other investment options, like real estate? In general, such other options offer the same risks and rewards as stock investments and they really only pay off over a longer period of time. If you’re looking at a longer-term investment and want to diversify as much as possible, things like real estate and bonds can be good choices, but, again, they’re not necessarily great options if you’re looking at the short term.

Once you’ve figured out the type of investment you want, figure out a sensible place to actually put your money. Shop around for a reputable bank that offers good interest rates on their savings accounts, good certificate of deposit rates, and online banking that allows you to set up automatic transfers. Ally Bank is a good option here. If you’re looking at stocks or other investments, shop around for a broker or investment house that can handle exactly what you need with minimal fuss. I use Vanguard directly for these things.

Once you’ve done that, set up a repeating automatic transfer that will move enough money into that new account each month so that you’ll achieve your goal. You can set it up however you’d like, but make sure that you’re putting in enough so that you’ll achieve your goal. For example, if you need to save $10,000 in two years, you should be putting in about $400 a month.

You can schedule the transfer weekly if that’s more convenient for you. In the above example, $100 a week would definitely get you to your goal.

What’s the benefit of doing this automatically? If you do it automatically like this, savings becomes a priority for you. You’re committing to paying yourself first; you have to account for the money going into savings because it’s going to happen, no matter what. Without an automated savings plan, you’re relying on your own decision-making process to put that money away month after month, and while you might be really committed to it now, almost all goals eventually hit an “enthusiasm valley” where short-term matters begin to feel more important than that big goal.

At this point, you have a goal, a timeline, a plan for saving that money, an account, and an automatic system in place for saving that money. What else do you need? You need to make sure that the money’s actually there each month.

Once a month (or once a week), the amount of money you’re saving is going to automatically move out of your checking account and move into your separate savings account for your goal. You have to be prepared for that in terms of your day to day spending. If you’re automatically saving $200 a month, that means your normal household budget has to be able to survive and thrive on $200 a month less than before.

Likely, that means turning back to the core of all personal finance principles, spending less than you earn. A large portion of this series, starting on the seventh entry and continuing until the sixteenth entry, focus on tactics for cutting back on your spending, while the eighteenth through the twenty-first entries focus on improving your income. Those two factors together are how you spend less and earn more.

To make that savings goal work, you need to be consistently spending that much less, earning that much more, or some combination of the two in a given month. Without that change in your personal finance habits, you’re going to run into some real difficulty making savings goals work.

So, your final step in this process goes right back to the beginning. You need to make sure that there’s enough of a “gap” between your spending and your earning that this savings goal isn’t creating a problem for you.

Personal finance is like a never ending wheel. You adopt goals and need to make financial changes to your life to achieve those goals, and then as you achieve goals and experience lifestyle changes, your goals change again, as does your methods for getting there. You keep moving back and forth between goals and methods, but as time goes on, the goals and the methods change and change again.

It’s up to you to stay on top of it.

The remainder of this series will focus on a number of standalone topics. Next time, we’ll take a look at insurance options.

The post 31 Days to Financial Independence (Day 25): Investing and Saving for Other Goals appeared first on The Simple Dollar.

Contributer : The Simple Dollar http://ift.tt/2jHbxlN