30 Day Investing Challenge, Day 17: How Much Should You Invest?
Now we’re getting to the good stuff: How much you should invest? A lot of people want a one-size-fits-all answer here, but that just doesn’t work. For one thing, people are different. People are messy. People have different needs and wants and paths in life. I never understand why the personal finance community always tries to pigeon-hole folks into thinking a 10-15% savings rate is right for everyone.
There are 4 ingredients that go into figuring out your savings rate: timeline, income, current lifestyle, goal type. If you’re 56 years old and have zero dollars saved for retirement, but make $10/hour then a 10% savings rate means you’re killing it. If you’re a 35 year old software engineer who blows through every paycheck and also has zero dollars saved for retirement, then 10% is not going to cut it. Each person’s needs are different, so each savings rate will be different.
How To Think Critically About Your Savings Rate
As I said above, there are 4 things you need to consider when thinking about your savings rate, specifically your investment savings. Let’s dive into each:
Timeline
When is huge. How much time is left is huge. If you’re 50 years old and only have $100,000 saved in retirement, but you want to retire at 65, that gives you a timeline of 15 years. Given average returns range between 8-10% (let’s go with 8% to stay conservative) that means you would need to save $2000/mo to reach $1 million. However, if you’re 25 years old and plan to work until you’re 70 because you love your job, that gives you 45 years and means you’d only need to invest $200/mo to reach $1 million. This is the ultimate illustration of time in the market. If you haven’t heard this saying yet, it goes “Time in the market is better than timing the market.” This basically means that if you start early, hold your investments for the long haul, and don’t constantly trade in and out of the market (which costs you tons in lost gains and fees), then you’ll win the investing game.
Income
Let’s go back to the example of the 56 year old. It’s all well and good to tell this person they need to save $2000/mo, but what if they only make $40,000/year? That’s a gross pay of $3,333/mo (net is probably more like $2800/mo). That means this person would have to live on 30% of what they make and save 70%, which is no easy feat in this day and age of inflation. Instead, the best thing to do is fit your savings rate in with your budget — see day 2’s challenge on getting your financial house in order and creating a 50/30/20 budget (you’ll want this for your action step below). The other side of this coin is asking the 56 year old if they even need $1 million. Given this person will probably be taking home around $1200 in social security and only makes $40,000/year, I would say they only need around $650,000 to retire comfortably with the lifestyle they already have. And that brings me to the next topic…
Current Lifestyle
Your savings rate is highly correlated to the lifestyle you want to maintain during retirement. If you’re living it up right now and know you’ll downsize once retirement comes, it’s okay to save less. If you’re living well below where you’d like to, but have an idea of what kind of life you want to have, you can stretch your budget to save for that lifestyle. Here’s how I personally did it: I am a follower of the FIRE (Financial Independence, Retire Early) movement, meaning I strive to save 50% of my gross income. Most of the FIRE movement folks like to radically cut their expenses so they can tout a 50% savings rate, but what they forget is that they’ll have to live this reduced lifestyle once retirement day comes. I decided to do the reverse: I increased my lifestyle and built a life I love, then I worked to increase my savings rate, mostly through debt pay down and increasing my income.
Goal Type
Not every goal requires a hefty savings rate. So far we’ve been talking about retirement, but what about those other goals you set in previous challenges? The ones that you want to accomplish in a few years and probably are less daunting than retirement? Let’s dive into an example: say you just paid off your car and you know you want to buy your next one in all cash. You have about 7 years left in your current car and you’re not willing to buy another vehicle that’s more than $25,000. So the savings goal here is to reach $25,000 in 7 years. If you use this handy investing calculator, you’ll be able to see how much per month you’d need to save based on what type of investment return you’ll get. For instance, if you save $250/mo you’d only need to a return of 5% to reach your goal.
Action Step: Calculate Your Savings Rate
Choose one of the goals you set in a previous challenge. Write out the timeline, amount, and goal type (short, medium, long term).
Plug your numbers into this investing calculator and see how much you’d need to save every month to reach this goal. For short term goals you can put a 2-3% return, for medium term 5%, and for long term 7-8% to get you going (we’ll talk about why in another challenge). Write your monthly savings amount down.
Repeat for all of your goals, adding up each monthly savings amount.
Take your 50/30/20 budget from day 2 and plug this savings amount into the savings category (remember we said we’d do this). Does this number fit within your budget? Are you over or under budget? If you’re over budget, are there some things you can adjust to make the number fit within your budget, like decreasing an expense from the 50 or 20 categories, or increasing one of your goals’ timelines? If you’re under budget, is there an area where you’d like to increase your spending or would you like to accomplish one of your goals faster?
I’ll see you here tomorrow for your next challenge: what should your asset allocation be?
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