This is something I consider important, at least when I define my financial goals. This post isn’t about how to get rich quick, but how to get rich slowly via savings and investing. In my opinion, over 20 – 30 years everyone should be able to at least achieve some level of financial independence, but most don’t. A recent survey showed 64% of Americans don’t have $1,000 in savings. This means many are living pay check to pay check.
I break down savings into three discrete steps. I consider setting up three goals to meet – emergency savings, when are you financially free, and when would you be wealthy. Since everyone defines these terms slightly differently, I’ll state what I mean:
- Emergency Savings – You have enough to last at least one year without income.
- Financially Free – Enough yearly income from investments to match your yearly expenses
- Wealthy – If you took out 4% of your net worth annually, your net worth would outlast your life expectancy.
It’s common for people to save for retirement, but not think about how much they will need when they retire. This is akin to driving without knowing where to go.
First Step – Emergency Savings
If you are starting from no, or negative net worth, you need a savings cushion. Most financial experts recommend 3 – 6 months. I recommend one year of emergency savings. Yes, I understand this could mean $60-70k in emergency savings. Having this amount gives you much more financial flexibility. For many having this much in savings takes off quite a bit of financial stress.
This money should be invested very safe and liquid investments, should you lose your job or have a financial emergency. I understanding this is somewhat hard in the current economic environment, but diversify, and pick your investments wisely.
Unlike most, I recommend setting up at least 2-3 months of savings before pre-payment of other debt. In my opinion, the ironic thing is when you have enough net worth, you no longer need a specific fund for emergency savings. Your emergency savings can be rolled into your other fixed income investments. What matters with emergency savings is how often you use it, and how long it take to unwind your investments. Based upon this, with your fixed income investments, you’ll need a portion set aside that is very liquid.
As I’ve stated from one of my first posts, what’s more important is cash flow, than net worth. In the race between the tortoise and hare, the tortoise won because of longevity.
Second Step – Financially Free
How much income do you need from your investments yearly before you are financially free? It’s a lot less than you think. For most people $60,000 – $70,000 is all that is needed to meet your typical yearly expenses. This is where creating your budget comes in handy. Create your budget, and figure out how much you need on a annual basis. This is your starting point for how much you need per year from your investments.
Let’s assume the money is invested conservatively at 5% return. How much do you need before investments equal $70,000 in returns? You only need $1,470,000 to generate enough cash flow to equal $70,000 in a year. Let’s round it up to $1.5 million. It’s an amount most can easily achieve over someone’s investing lifetime. This is another reason why you should invest often and invest early.
This, of course, does not take into account inflation and taxes. I’m not suggesting you shouldn’t invest past this amount either. Quite the opposite. The goal of this exercise is when can you say you have at least enough saved where if you couldn’t work another day in your life, you would at least have a decent sized safety net. This is the point when you tip the scale, so to speak. After this point, you will generate more income with your savings, then what you will need on a yearly basis to live.
Final Step – Wealthy
Once you’ve past the first goal, the wealthy goal is the fun part. Unfortunately, many people in the United States don’t get past the first goal, let alone the second.
This goal is where you have enough savings you can take out less than 4% of your total saved. Using the numbers above: this is around $3.5 million. So you need at least $3.5 million, and your money should outlast you, instead of you outlasting your money. For more details, see one of my first posts: How Wealthy Are You?
Once you have enough investment income, you should be locking in capital gains. Your sole investment objective is to make sure you keep up with the hidden tax – inflation. This isn’t to say you should be investing for growth, but your primary objective is to keep risk to a minimum.
Of course, these number vary from person to person, but the basics still apply. Having these target goals is important because you know what you are shooting for. If you don’t, you are wandering aimlessly.
Readers: How much do you need to be considered wealthy?