Mother and daughter are at home, they are holding 2020. balloon numbers and communicating on a video … [+]
Did you make New Year’s resolutions this year? Unfortunately, there’s a pretty good chance that any resolution we make won’t be kept. This can be particularly true of financial goals, which can often feel confusing and overwhelming. Here are some steps to help make those financial resolutions into a reality.
1) Set SMART goals. When we set a vague goal like “save more money” or a seemingly insurmountable one like “pay off all debt,” we’ve already set ourselves down the path to failure. Instead, you want your goal to be SMART: specific, measurable, attainable, realistic, and time-sensitive. Rather than “save more money,” a SMART goal might be to save an extra $5,000 for emergencies by the end of the year.
2) Determine how you’ll invest for each goal. For goals to be funded within the next five years, you’ll want to keep your money somewhere safe like a bank account or money market fund that just earns interest and doesn’t fluctuate in value. That’s because if you invest the money in something more aggressive, like stocks, it could lose value and not recover by the time you need the money. The potential benefit of a higher return is also much less when the money has such a short time to compound.
For longer term goals, it probably makes sense to take some investment risk. Otherwise, you face the risk of having your purchasing power reduced by inflation. A 1% investment return with 2% inflation is actually losing 1% a year in real terms of what you can buy with that money.
Having even a small percentage in stocks can give you enough growth to at least keep pace with inflation. The exact percentage depends on your comfort with risk. You can use this short questionnaire for some guidelines on how to allocate your investments between stocks, bonds, and cash. Just keep in mind that your time frame is how long your money might be invested, so retirement would be a long-term goal even if you’re retiring in less than 5 years, unless you’re planning to use the money to pay off your mortgage or purchase an immediate annuity.
The more you invest in stocks, the higher your expected return is in the long run. I like to estimate a 6% return for aggressive investors, 5% for moderate, and 4% for conservative. All are below the average long term returns to be on the safe side.
3) Calculate how much you need to save per month. You can use this Debt Blaster calculator to see how quickly you can pay off debt by making extra payments towards your highest interest balance, and then putting those payments towards the next highest interest debt once it’s paid off. For short-term saving goals like an emergency fund or a down payment on a home, you can use a relatively simple calculator like this one to see how much you need to save per month given a certain inflation rate and return on your savings. For more complex goals, you can use this calculator for retirement and this one for college planning. Just remember to use expected rates of return that match your time horizon and risk tolerance.
4) Look for tax-advantaged ways to save. Some examples are your employer’s retirement plan or an IRA for retirement. Coverdell Education Savings Accounts, 529 plans, and US Government Savings Bonds are all ways to allow your savings to grow tax-free for qualified education expenses. However, there may be penalties if you withdraw the money for other purposes.
5) Minimize your investment costs. Within each account, look for the lowest cost options to implement your investment allocation based on your time frame and risk tolerance. Studies have found that when comparing similar mutual funds, low costs are the best predictor of future performance. In particular, index funds that simply track a given market typically have the lowest fees and trading costs, so see if they’re available in your account.
6) Automate your saving. This is the most important step because you can have the perfect goals, the perfect plan, the perfect account, and the perfect investments, but they won’t mean anything without actual savings to invest. By automating your savings, you make sure that they take priority rather than just saving whatever you happen to have left at the end of the month. You can do this by payroll deduction or an automatic transfer from your bank account.
7) Adjust as needed. At least once a year, you’ll want to revisit your goals, re-run your calculations based on your actual investment returns, see if tax laws have changed, and re-balance your portfolio. If your investments are down in value, this is not a reason to sell them but just a natural part of the cyclical nature of investing. Instead, try to see it as an opportunity to purchase more shares at a lower price through your automatic investing and re-balancing.
As you can see, you don’t have to spend hours researching or following the stock market to achieve your financial goals. When you break it down into these relatively simple steps, you may find that it actually requires a lot less time and sacrifice than you thought. Don’t you wish you could say the same thing about dieting and exercise?