Most of the investing advice that I have come across agrees on one thing. Money that you need in the next 2-3 years should not be invested in the stock market. However, I have seen no one talk about the corollary to this.
Money that you don’t need in the next 2-3 years should not be in your checking/savings account and should be invested in the stock market.
Question is how do you figure out how much money you need and don’t need in the next 2-3 years. Let me attempt in providing an answer to this question. As you already know, this question is very personal, like most other things in “personal” finance. So, everyone’s answer is going to be different. But you can figure this out by preparing a budget for your family. In this article, I want to talk about making a budget and why that is important. First, let’s talk about what budget means. In simple terms, budget refers to a financial plan where you list all your cash inflows and outflows. I like this definition:
Budget is a way of telling your money where to go instead of wondering where it went.
You can make a budget on paper, on Excel or in a spreadsheet. There are some paid apps as well such as Mint, YNAB etc. I recommend using a spreadsheet to make budgets. It is free and when you prepare it yourself instead of an app, it gives you a connection with your money that you don’t get when you are using an app to make a budget. Here is one way you can use to prepare a budget for decision-making.
- Write down all your cash inflows. This includes your paycheck, any other income from a side hustle, your college scholarship, or any other cash incoming from other sources.
- For listing your cash outflows, you should follow the 50-30-20 rule. I will explain this rule below. List all your expenses in these two categories.
- Fixed Expenses/Needs (This should not exceed 50% of your post-tax Income): Fixed Expenses include those expenses that you must pay such as rent or mortgage, utilities, groceries, internet, phone, any loan payments that you are making etc. This section can also be called Needs.
- Discretionary Expenses/Wants (This should not exceed 30% of your Cash Income): This category includes expenses that are not fixed and are classified as Wants such as shopping, vacations, going out to eat, streaming services such as Netflix, Amazon etc. Some people may consider going out to eat as a need and that is okay. Just make sure that these two sections combined (needs and wants) are under 80% of your income for a healthy budget.
- Savings (Minimum 20% of your Cash Income) You should target a minimum 20% of your income as savings and build an emergency fund for at least 6 months of your total expenses. Once you have enough money saved for an emergency fund, you can take the next step where you are ready to invest your money to take advantage of compounding.
Why do you need a Budget?
You are budgeting so that you can build up an emergency fund for yourself and decide how much money you can afford to invest for the next 2-3 years. The stock market can do anything in the short-term (less than a year). However, leave your money invested in index funds for medium to long-term (2-3 years) and you will be amazed by the growth. Saving and budgeting alone is not enough. Investing will enable you to reach financial independence (FI) faster. You are not budgeting because you want to find out how much you spent on coffee and groceries every month.
You are budgeting because you want to see how much money you can transfer to your high-yield savings account every month, how much you can transfer to your Roth IRA and how much can you transfer to your brokerage account. In my research, I have found that the real difference between people who are at the top of the ladder (financially independent, debt-free) have saved a substantial proportion of their income, and found something profitable where that could be put to work. I have also discovered that many, if not most, of these people didn’t earn hundreds of thousands of dollars a year, nor win the lottery, nor have their wealth given to them. They just had a little bit of savings invested on a regular basis that could add up to real wealth over time, and what one really needed to ensure success in this regard was a consistent method of choosing investments.
It doesn’t take that long to work on your budget and if you are spending about 15 minutes per week then that is enough. You can easily list all the expenses looking at your bank account and credit cards in that time. This 15 minutes per week investment will pay off big in a few years of time. Many people incorrectly think of budgeting as restricting your spending and it isn’t. It just means planning and allocating dollars to your pre-existing goals.
Working on your budget will help you to keep track of your spending and you will not have an overdraft on your bank account. Overdraft can result in high fees on your accounts. Your emergency fund will allow you a peace of mind and help you avoid high-interest credit card debt. You never want to get stuck in the trap of high-interest credit card debt. I am always surprised to see how many people are living paycheck-to-paycheck. They are earning a good salary but they are not building their net worth because they are spending everything that they earn and some more. The biggest advantage of budgeting is to find a gap between what you are earning and what you actually absolutely have to spend each month. Sort that out. Once you find that gap and invest that gap over time, it can work wonders for your financial independence.
I leave you with this. Let’s say you start working at age 25, start budgeting and open a Roth IRA, and then follow this plan
-Initial investment: $1,000
-Monthly investment: $500
-Annual investment return: 9%
-Time period: 35 years
You will have $1,314,678.50 at age 60, tax-free! Now increase that annual investment return to 10, 11 or 12% and see what happens!
Do you prepare a budget? What apps have you found most beneficial? Feel free to share below.