Recently, Steve got a substantial raise. His friends have recently convinced him of the importance of becoming an owner in the economy. Eager to take part in the potential for compounding growth, Steve finds himself facing a difficult question of what to do with the added income: How much should he invest?
Broadly speaking, a good rule of thumb lies in farmers’ wisdom: 1/3 to store (Save), 1/3 to plant (Invest), 1/3 to eat (Spend). These three areas fulfill these functions:
- Save: Most Americans have less than $700 in their emergency savings. By continuing to contribute to savings, Steve builds up his safety net in case of some sort of catastrophic event to his income. This should provide Steve with peace of mind currently, and in the future should such an event occur.
- Invest: Money that’s invested starts to work for Steve, even while he’s asleep. This portion of his wealth increases his wealth even more over time.
- Spend: Money exists to make our lives easier. Even as Steve puts his new income to work for him through investments and savings, it’s also important to use money to increase his standard of living. This gives him positive reinforcement for his successful habits. Whether it’s indulging himself in some way, or giving to a cause or a person he cares about, his money will fulfill its purpose of providing his life with enjoyment.
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The more specific answer to this question depends on several factors. He can start by answering these questions:
- How much does Steve already have in Savings?
Consider this: If Steve loses all of his money in his investments, will he have enough in Savings to protect him if his car needs a new battery, or if he loses his job?
Between cash accounts (Checking and Savings accounts) and emergency funds (Retirement accounts) Steve should aim to be able to pay his bills for two years if he needs to. This will give him the financial breathing room to weather a market downturn, a job loss, or a serious illness.
If he hasn’t reached this point yet, then he should still contribute some of his monthly savings towards it. But if he’s already hit this goal, he’ll have more money to play with that he can put towards investing.
- How much does Steve save each month?
Steve should also look at how much of his monthly income he’s able to put aside each month. If he’s not able to put much money aside each month, or not able to save any money at all each month, Steve won’t have as much income to risk in investments. He’ll need a larger portion of his money to keep him safe in case of an emergency.
- What kind of liabilities (debts) does Steve have?
If Steve has a lot of debt, he might be better off putting less into investments, and more towards paying off debt. The math is pretty easy to see: If his credit card interest is about 20%, and the real returns from investments are around 8%, the credit card interest will always win.
These three questions are a great starting point for Steve to start planning what to do with his new income. If he still has questions, he should consult with a licensed financial advisor who can help him develop a strong financial plan.
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