You might think that the most important investment decision you have to make is what to invest in. I agree this is a pretty important question. But it’s equally important (if not more so) to know how much to invest. Here’s why.
You might select the best investment possible, but if you don’t invest enough it won’t matter. Sure the percentage return will be great but if you only throw down a small part of what you could have, you are ignoring opportunity – big time.
And the opposite is also true. If you invest too much you will could find yourself in a precarious financial situation before you know it. People who invest too much often don’t have enough money to cover short-term needs and emergency situations as they pop up. When they hit a bump in the road, they either have to cannibalize their investments or run up heavy and expensive credit card debt. Either way, it’s a bad scene. A very bad scene.
How to Find the Right Balance
Some people make this very complicated. But I like to keep things as simple as possible. I figure out how much I can’t invest and then, invest what’s left. You can do that too just by asking yourself a few questions:
1. Emergency Funding
You really can’t invest your emergency stash so the first question to ask is, how much disaster cash do you need? That may seem like a very difficult question to answer because you can’t predict the future.
While it’s true that you can’t ever know what’s going to happen for sure, you can make a pretty informed guess about how much cash need to keep handy. You can do that by thinking about the worst financial crisis you’ve had to deal with over the last 10 years. In my experience, that’s a good gauge of what you might need for emergencies in the future
This isn’t a guarantee and it’s not very scientific either – but it works “mon ami”. Think about your own situation over the last decade. Let’s say the worst financial disaster you had to deal with cost you $10,000 5 years ago. Is it possible that you might need $100,000 for an emergency down the line? Yes. But is it likely? Not very. For our example, let’s just say that $10,000 is our number for emergency set asides.
2. Monthly Spending
The next question to ask yourself is how much you need to live on each month and how stable your income sources are. There are a variety of ways to calculate your average spending but my favorite method is to let my bank statements tell me. I’ve written a few posts about this and I strongly suggest you read them and use those tips.
What’s cool is it only takes about 5 minutes a month to figure this out and it is a far more accurate measurement than other approaches that take hours each week.
Next, consider how stable your income is. When people tell me there jobs are very stable, I suggest that they still keep 3 month’s salary available anyway. If their incomes are very volatile, I suggest they keep 6 to 12 month’s salary tucked away. On the other hand, if all your income comes from pensions and reliable investment income, you might need even less cash laying around.
For our purposes, let’s say you need $4,000 a month to live on and you have a very stable job. Using the formula above, you’d would earmark another $12,000 for an “income emergency”.
Pretty simple…right? I told you so. OK. So far we’re up to $22,000 we can’t invest.
3. Foreseeable Expenses
The last question you need to answer before knowing how much to invest is to ask yourself if you’ll need a large amount of cash over the next 1 to 2 years. For example, if you know you’re going to need cash for a home purchase, new car or whatever, you really shouldn’t invest that money and you need to keep your powder dry.
Again, you won’t earn much interest on that money but it just doesn’t matter. You can’t take any chances. Right? Think about what might happen if you invest it and then need that cash later on. If you need to sell at a time when the market is down it could derail your plans to buy the house, car or other major item. Not acceptable friend.
For our example, let’s say you don’t have any large outlays on the horizon. At this point, it’s pretty easy to figure out how much you can invest. You already know that you need about $22,000 for emergencies. So that means you should invest everything above that amount. Simplicity itself.
As a further refinement, think about how much money you might need in 2 – 5 years, 5 – 10 and ten and beyond. Each bucket should be invested differently. That’s because the closer it is to the time you need the money, the more conservatively you should invest it.
Knowing how much to invest is not difficult. Just be very clear on how much you should not invest. But that money aside and get to work with what is left over.
Do you agree with this approach? What would be a better way to figure out how much to invest?