ultimate financial strategy. Actually, it's more—it's a way of life. If you want to be able to invest and accumulate wealth to help yourself or others in the future, you simply cannot spend more than you earn. Living beneath your means and becoming a saver are so critical to your financial success that I'll talk about it here and again in the next chapter. And I'll discuss some tools and techniques to help you do it.
Effective saving isn't just tucking away as much money as you possibly can. It's also knowing where to put your money so that it will earn a reasonable rate of return and be there when you need it.
A friend whose firm is one of Vanguard's large corporate clients frames the concept as follows: “When I'm talking to our employees about the importance of saving and investing, I urge them to think of themselves as ‘personal financial entrepreneurs.' We're all financial entrepreneurs, running our own financial operations, first in our working years and later in retirement.”
As a financial entrepreneur, you'll want to create an income statement. In business, that's a summary of how much profit (or loss) a company had during a certain period of time. For you, it's the same thing. Your personal income statement would list your revenues (e.g., your pay, plus any investment income or gifts you receive) and your costs. The costs would include your fixed expenses (e.g., taxes, mortgage, insurance premiums, student loan payments, car payments, and the like) and your variable expenses (e.g., food, clothing, entertainment, charitable donations, and discretionary items).
When examining your income statement, if there is money left over after expenses are subtracted from revenues, you'll have a net profit that is available to invest. If you have no net profit, and in fact are borrowing to maintain your lifestyle, you are operating at a loss.
Living below your means is tough in a materialistic culture in which advertisements constantly play to our egos and the media provides endless images of “the good life.” But the unsung benefits of being a saver are priceless. You'll have enviable peace of mind because you won't have to worry about making ends meet. You won't feel wistful about your goals because you'll know you're traveling steadily toward them. And you'll know that, if need be, you're in position to withstand unexpected financial challenges. Let's face it: Unexpected financial needs occur in everyone's lifetime. People get laid off from their jobs, incur extraordinary medical expenses, or need to offer financial assistance to a family member. If you're a saver following a plan, you can weather those challenges far better than people who spend every penny they earn.
But what about the “good life”? Don't savers miss out? No, they don't. They simply gain control. Living the good life isn't just about material possessions—it's also about possessing financial flexibility and broadening your options, and, importantly, about having things to which to look forward. Accumulating capital is the reward if you choose saving in the saving/spending trade-off.
If you have a job and are earning money, the most fundamental financial planning question is this: Are you going to spend it all on current needs and wants, or will you set your living standards below what you can afford so you can save some of what you earn? Even if you can afford many things, the reality is that you cannot afford all of them. Before you decide how you'll spend your paycheck, decide how much you want to be setting aside for saving and investing.
Two additional thoughts on saving:
1 It's never too late to become disciplined about saving, but the sooner you develop the saving habit, the easier it will be to achieve your goals.
2 It's a good idea to reevaluate your savings habits from time to time, particularly when going through major transitions in life.
Think of Your Financial Needs as Imaginary Buckets
One of the most useful concepts in financial planning is to think of your financial needs as “buckets.” The idea is to determine how your money needs to be divided among the buckets, and then be very disciplined about filling those buckets. These are typical buckets of most people:
Current expenses. This is what you live on—the money you use for your mortgage or rent payments, food, clothing, car payments, and other essentials.
Emergency fund. Many experts recommend that you have six months' worth of take-home pay available to meet unexpected difficulties, such as a short-term layoff from your job or large expense.
College. The cost of a college education keeps climbing, and though you can take out loans, you'll come out ahead if you can pay for as much of it as possible out of savings.
Retirement. Many Americans today spend a quarter century or more in retirement. You can't count on Social Security payments as your sole support for all those years. Most people will need to draw on their own savings to live comfortably while they continue to pay taxes, medical insurance, and everyday expenses.
Other goals. Add as many buckets as you want for other savings needs, such as replacing your car, buying a first or second home, taking care of elderly parents, giving to charity, or anything else you deem essential.
You'll note that I've included charitable donations to the other goal bucket. At the risk of sounding sanctimonious, my personal view is that giving is important, and I encourage you to build it into your financial plan. Anyone who has accumulated money to invest should be willing to give something back to society. You don't have to be wealthy to give to a house of worship, the local fire department, your alma mater, or national fundraising organizations that serve your community or the broader world. Even small contributions can make a difference when they are combined with those of other givers. And they will make a difference in your own life, too. As my wife and I have increased our giving over the years, we've found it deeply satisfying to be supporting programs to help others, and we're most pleased that our children have adopted this same point of view.
Once you have designated target goals for each of the buckets in your financial plan, you will need to think about where you will keep the money. The idea is to maximize the return for each bucket within the parameters of your time horizon and risk tolerance. As a result of the varying issues in each situation, different buckets will call for different approaches.
Saving for Short-Term Needs
You need immediate access to the money to meet current expenses, so you would eliminate long-term investment vehicles like stock funds and long-term bond funds from consideration. A rule of thumb in investing is that you should not invest money in stock funds that you will need in less than five years. Most people use a checking account for the money that's needed to meet current expenses. That's typically a checking account that pays little or no interest, so the trade-off for the convenience of this account is that you are earning virtually no return.
Your rainy-day fund is a slightly different issue. Since this is money that you don't plan to touch except in an emergency, leaving it sitting in an interest-free bank account makes no sense whatsoever. A better choice would be to invest it in a money market fund, an ultra-short bond fund, or short-term Certificates of Deposit, which offer some return while still being relatively liquid, or readily available should an emergency arise. Such a choice will enable you to make your money work as hard for you as possible. If interest rates are low, you may wonder what the fuss is over a return of 1% or 2%. But ask yourself a simple question: Would you rather have the 1% or 2% in your pocket, or let the financial institution have it? Small amounts of interest eventually add up to impressive sums. Suppose you put $10,000 in a savings account that pays 2% a year, and it sits there untouched for 25 years. It will turn into more than $16,406.
Saving
