As most of us are raised in the culture of instant gratification and are accustomed to using credit cards for everything. Too often we shun the idea of saving until we are suffocated with credit card debt. We have to shift our perception of savings to something that gives us freedom to purchase things we want down the road and get excited about growing our money.
The most common misconception out there is that to have a million you need to make a million. In fact, all it takes is a little bit of planning, a little bit of strategy and some 5th grade math.
What we must understand is that we can grow our money just like banks and credit card companies grow their money. They do it by charging us interest on student loans, car loans, mortgages, credit cards, etc. Because we eventually repay them the principle as well as the accumulated interest over time, they often double, triple and, in case of the credit cards, quadruple the amounts they lend us to begin with. There is a positive spin here – interest works both ways. If we are paid interest, our money can double, triple and quadruple as well.
There is a very basic rule that describes how interest doubles our money. It is called the Rule of 72.
Just take the number 72 and divide it by the interest rate we hope to earn. That number gives us the approximate number of years it will take for our investment to double. So if we were to earn 3% on our money, our assets would double roughly every twenty four years (72:3=24). At 9%, however, our assets would double every eight years.
Just to see the difference the doubling periods make, imagine investing $10,000 when you are 22 years old. Averaging 3%, we will have about $40,000 at a ripe retirement age of 70, averaging 9% we will have over $640,000. Which retirement strategy would you prefer, 3% or 9%?
And while these are hypothetical numbers and there are no risk-free investment vehicles that guarantee a 9% annual return, there are investment vehicles like mutual funds that have averaged 9-12% over long term periods of 15 to 25 years.
To prepare for anything life throws at us, we must set up 3 types of accounts targeting different rates of return and taking on different levels of risk.
1. An emergency savings account should be easily accessible and have enough in it to cover 3-6 months of your living expenses.
Usually it is a savings account at our bank and we can gradually build it up by setting an automatic transfer of $50-100 every month from our checking to our savings.
When our car breaks, or we find ourselves between jobs, we would use money from this account. This money has no risk or growth associated with it and its primary purpose is to be our safety net for emergencies so we do not have to use credit cards.
2. A mid-term investment account should be accumulated for major purchases within 3-7 years.
We all have some major financial needs in the future, like funding a wedding or a honeymoon, buying a home or doing major house renovations, international travel or starting a business. Whatever it is, we must prepare and accumulate some assets.
I see people digging themselves into financial hole by borrowing from 401k, cashing out retirement and getting into credit card debt just because they did not plan properly. A mid-term account should be an individual or joint investment account also funded monthly with $100-200/mo and invested conservatively in diversified mutual funds with high degree of bonds. It should target 3-5% as an average rate of return taking on moderate risk.
3. A wealth-building account should be designed for the long term and is typically associated with qualified retirement plans like 401k, 403B, or an IRA.
In a 401k, we must seek advice from the 401k providers to create growth-focused risk-managed portfolios and invest enough to get the maximum match the employer is offering.
For example, if employer matches 5% of our gross salary, we should set it up so that 5% is automatically contributed to our 401k every month. For completely tax-free growth of a portion of our assets, we should find out if our employer offers a Roth 401K and chose that option.
This account should target to average 9-12% over a long period of time, and experiences significant market fluctuation - assuming the highest risk out of the three accounts.
While we can start learning more about investing by reading online, I advise you to find a financial professional who will assist us with setting up our savings and investment accounts.
There is risk and volatility associated with investing and it is easy to make wrong emotional choices when we don't have anyone to talk to.
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