Once you define your financial goals, you should understand how much you need to invest to reach them. However, the answer is not as simple as it may seem.
Once you decide to start investing, you might wonder how much you need to invest to reach your financial goals. Your first instinct might be to invest whatever is left at the end of the month. However, as usual, it is not as simple. In the end, the amount you should save or invest depends on your financial goals and requirements.
Before you start investing, you should not just think about how much money you should invest but also how much you actually need to invest. Ultimately, how much you should invest is highly dependent on your investment goals and time horizon. You should look into what you want to do with the invested money and, more importantly, when you want to do it.
Do you want to retire early? Then you should make sure that you have some money invested in a non-retirement account, as investments in a retirement account may not be accessible before a certain age.
Do you plan to start a business? Then you should invest your money in a way that reduces your taxes when pulling it from your investment account.
Are you saving for a vacation, a house, a car, or an emergency fund? Then investing might not be the best choice at all. Investing is often too risky for these short-term investment goals as you risk losing the value of your investment in case of unexpected turbulence in the market. Instead, it would be best to look into saving the money in a savings account where you can easily and quickly access it without a potential loss in value.
Saving and investing help you build your wealth and reach your financial goals, like retiring with a comfortable nest egg or buying your own house. And unless you are fortunate enough to inherit a large sum of money or win the lottery, you, unfortunately, cannot avoid to start investing.
Failing to save and invest any money can have serious consequences. For example, you might not be able to live a comfortable life after you retire and might need to keep working to pay your bills. In addition, your health-related costs will rise as you get older. As a result, you will become entirely dependent on others to maintain your current lifestyle.
You might be tempted to rely on social security or your pension. However, as the population in most western countries is slowly aging and reaching a higher life expectancy, there will be fewer and fewer people financing your pensions. Therefore, it is hard to know whether these systems will still be around once you reach retirement age. You most likely cannot expect to receive a similar pension as your parents or grandparents have received if they are. But even if social security or your pension turns out to be sufficient, it is still better to invest consistently and know that you can always support yourself no matter what.
Many people postpone investing because they think they cannot afford to spend extra money right now. They want to wait until they make more money. However, when the time and their household income increase, they rather increase their living expenses than start investing.
Everyone can invest if they want to. However, most people have it backward and invest whatever is left at the end of the month. A better approach is to invest a fixed percentage of your income directly after receiving your salary, ideally using an automatic withdrawal from your bank account. The remaining amount then is yours to be spent as you need.
The unfortunate truth is that most people do the opposite, though. They are living paycheck to paycheck and never start investing. For them, investing is not a priority. However, they miss out on their most significant opportunity to achieve financial independence, reach their financial goals, and live the life they want.
Keep in mind that even investing small amounts can already make a dent in your financial goals. While it will take longer to achieve your goals with smaller contributions, you can still benefit from compound interest, no matter how much you invest. In addition, there is the added benefit that you build up a habit of investing regularly, even if it's just small sums.
It never hurts to have some extra savings or investments left. But it will most definitely hurt not to have them. Make investing a priority and reach your financial goals!
You might be tempted to just invest a lump sum and be done with investing. If you invest it with a high rate of return, you can benefit from the power of compounding, so you should still be able to reach your financial goals, right?
While the answer depends on your specific financial goal, the answer is most likely no!
Investing in a lump sum might work for longer-term financial goals, like saving for your children's education, where you can take advantage of the effect of compounding. However, for financial goals which require a much higher amount of money, like funding your retirement, you are most likely out of luck when investing a lump sum. For example, to retire with ~$1M in 40 years, you need to invest a lump sum of at least ~$80k at a target savings rate of 6.5%. Such a high lump sum is most likely out of reach for most young people and beginner investors.
A better alternative to investing a lump sum is to invest a fixed percentage of your income. There are two advantages of this approach. First, you can still benefit from the power of compounding and achieve the same financial goals that we mentioned previously with a lower impact on your expenses. Second, your savings rate automatically increases as your income increases. Therefore, the more you earn, the more you will benefit from compound interest.
As we mentioned above, the exact amount you need to invest from your salary will vary depending on your financial goals. The general rule of thumb is to invest at least 15-20% of your monthly income if you plan to invest for retirement. But if you got more to put away, that's even better!
There are two common rules that experts recommend for planning your investments:
Let's look at both rules and see how they can help you consistently invest money.
With the 50-20-30 rule, you will divide your salary into three categories:
Essential expenses include any expenses that you cannot avoid to keep up with your current lifestyle. These may consist of rent, housing costs, electricity, water and heating, groceries, public transport, gas, etc.
Ideally, savings and investments are solely dedicated to retirement contributions and your short-term financial goals. However, the 20% may also be allocated to paying off your debt and setting up an emergency fund, which you should do before starting to invest.
Finally, the remaining 30% will go towards nonessential expenses, like clothes, ordering food or eating out in a restaurant, monthly subscriptions, paying for the gym, etc.
One downside of the rule is that it only works if you have a stable income that doesn't fluctuate too much. For example, your income might be too irregular to follow the 50-20-30 rule if you are self-employed.
In addition, it also highly depends on the overall average living costs in the place where you live. For example, if you live in a big city, like New York, London, or Berlin, your overall living costs may be higher than in cheaper locations. The same issue also applies if you're working in a low-paying job with hardly anything left of your salary once you paid for essential expenses.
A more simplistic alternative to the 50-30-20 rule is the 80-20 rule. With the 80-20 rule, you don't have to categorize your expenses. Instead, you simply take 20% of your paycheck and invest it once you receive your salary. However, like the 50-20-30 rule, the 80-20 rule also only works if you have a sufficient income to afford to invest your money while paying for essential monthly expenses.
In the best case, you set up an automatic withdrawal of the 20% to avoid being tempted to misuse the amount for something else. By using an automatic withdrawal, you treat the amount as an expense towards your future self that you never had available to spend in the first place.
As you don't have to categorize your expenses, the 80-20 rule might be easier to follow if you have an unstable income. If you're a bit short on money in some months, you can simply reduce your other expenses without sacrificing your 20% savings.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.