Having a good income is not enough

It’s what you do with that income that matters

The most common question I get when meeting with clients in their 30’s and 40’s is, “how do I save money?” These are folks who often make between $200,000 and $400,000 per year and yet never seem to know where it all goes. While the internet offers technology solutions like mint.com which helps you track your spending, that doesn’t necessarily help you improve your savings.

The good news is that this is not a new problem and the solution already exists. When I was very young (12 or 13 years old) I read a book by Charles Schwab titled The Guide to Financial Independence. In this book Schwab covers many items, but 3 really stood out to me.

Piggy bank background image for a Danville Financial Advisor Firm

#1: Pay Yourself First

What this means is that you need to save money automatically as you get paid as opposed to saving whatever is left over at the end of the month. Let me give you an example. If you have a 401(k) at work and money is automatically withheld, then you can only spend the net amount you receive. Even if at the end of the month you had $0 left from your paycheck, you would still have saved money that month because you paid yourself first! This is a simple concept that everyone should be doing.

#2: Invest What You Save

Saving money is the first step. The next thing to determine is how you are going to invest what you have saved. Depending on the type of account your savings are in may affect the investment options you have available. For example, most 401(k) plans limit your investment choices to a select group of mutual funds or allow you to select a model portfolio based on your time horizon and risk tolerance. Other types of accounts are not as restrictive and you have many investment choices ranging from Certificates of Deposits (“CDs”) and money market accounts to investments that have a higher level of risk associated with them, but on average have higher percentages of returns.

It is important to start investing as soon as possible, because the time value of money, the more you invest now the greater the growth potential due to the compounding of interest and earnings. A 25 year old that saves just $5,000 per year until age 65, and realizes an annual return of 7%, will have $1.1M when they retire. The earlier you start the better so start today! This chart or graph is hypothetical and for illustrative purposes only. It is not intended to show the performance or return of any particular investment. Past performance cannot guarantee comparable future results.

#3: Diversify Your Assets

We all know that we shouldn’t “put all of our eggs in one basket”. And yet when it comes to investing that is what many people do. Diversification doesn’t simply meaning owning more than one stock or more than one mutual fund. True diversification means spreading your money across different economic sectors (energy, technology, industrials, etc.), and investments with different characteristics (such as small cap companies vs. large cap companies). Our economy goes through business cycles that fluctuate based on the rate of growth in economic activity. Economists have studied these cycles and determined that on average certain sectors outperform other sectors during different phases of the business cycle, such as the expansion and contraction phases. The whole idea is the economic landscape can change in a blink of an eye but a diversified investor can weather and profit from any storm. Diversification (Asset Allocation) does not does not guarantee a profit or protect against loss.

These are folks who often make between $200,000 and $400,000 per year and yet never seem to know where it all goes

Having a good income is not enough, it’s what you do with your income that matters. Unfortunately, pension plans are a thing of the past and college costs are rising. If you are a parent you need to simultaneously save for your retirement and for your kids’ education costs. The right vehicles in which to save already exist, whether that’s a 401(k) plan at work or a 529 plan for the kids. Dealing with those is the easy part. The hard part is setting up a system to automatically save a portion of your income into these vehicles each month, and then as you receive extra income from bonuses or commissions. Set a specific #, 10% or 15% of your income goes to retirement, 5%-10% goes to college savings, and the rest can be spent and used to pay taxes. Your spending will be guilt free because you will know you’ve already saved for the month and can enjoy the rest!

Call or write if we can help you establish a game plan to pay yourself first.