Have you decided that this year is the year for you to learn how to invest? Are you switching from intense focus on debt repayment to developing your core financial strength?
If you've gotten to the point in your financial journey where you have some margin in your budget, but you don't have a plan for your income, then you'll probably fall into one of three camps: cash hoarders, lifestyle inflaters, and aimless wealth builders. Although I don't see anything that is particularly egregious about falling into these camps, I want you to do better!
Particularly, I think that the vast majority of people who have paid off their debts (or their high interest debts depending on their personal opinions) should make an attempt to build wealth in a way that accords with their values. This is why I recommend the "investing snowball" which is just a fancy name and a little bit of structure for how my husband and I initially started to build wealth, and our plan for building wealth after our Balls to Walls experiment is done.
If you haven't decided on a cohesive savings and investing structure, let me recommend continuing to read about the investing snowball. In particular, my favorite younger sister should pay attention, because this is what I was going to explain to you over break, but then we got busy doing nothing :)
The investing snowball introduced:
The investing snowball is essentially the debt snowball in reverse. Instead of paying off the smallest debt with the largest amount of money, the investing snowball helps you direct the majority of your available income to the goal that you wish to accomplish the soonest while making "minimum payments" on the rest of your goals.
The major difference between the debt snowball and the investing snowball is the mindset required to accomplish your goals. When it comes to debt payoff, extreme focus, intensity and even anger can fuel the fire of debt payoff. When it comes to building wealth, extreme focus, intensity and anger tend to be counterproductive (not only because they cause you to make stupid decisions, but also because they make you narrow-minded and unhappy). Rather than the "extreme" mindset, I recommend adopting an attitude of saving "as much as I reasonably can."
How to define goals for wealth
The investing snowball requires people to define three types of goals: short term goals to maintain a position of financial strength, worthwhile intermediate goals, and retirement or income cessation planning goals.
As a part of defining these goals, you will need to define the following: goal name, life reason for goal, terminal amount required, when goal needs to be met. To clarify, I will show you our goals.
Short Term Goals (anything that needs attention in the next year):
Name: Maintain Emergency Fund
Life Reason: To give us the freedom to undergo hardship without having to stress about money.
Terminal Amount: $40K
When goal needs to be met: Already met, but we e-fund should be replenished as soon as possible anytime any amount is used.
Name: Pay for delivery of baby
Life Reason: We love babies and will need to deliver ours
Terminal Amount: $6K (high end estimate)
When goal needs to be met: March 2016
Some other goals that are likely to fall into the short term bucket include: Car replacement (we drive cheap cars), vacation fund, wedding funds (not for us, since we're already married) and home renovation funds.
Once a short term goal is funded, you can immediately spend the funds, or you hold onto the funds until an ideal spending opportunity presents itself. Remember, money that isn't spent can go to another goal!
Worthy Midterm Goals (anything that needs attention in between one year from and when we retire):
Name: Save money for kids college
Life Reason: Promote a debt-free transition to adulthood for our children
Terminal Amount: $100K per child
When goal needs to be met: 2035
Name: Fancy House Fund
Life Reason: I want to build a house with an attached apartment before our parents get old
Terminal Amount: $275K
When goal needs to be met: 2030
Name: Sabbatical Fund
Life Reason: In case we both want to take some time off from work, but we haven't reached financial independence yet
Terminal Amount: $100K
When goal needs to be met: 2025
Some other types of mid-term goals include: Mortgage payoff, Car funds (for people who like fancy cars), down payments for first homes, "opportunity funds" for those who are entrepreneurially inclined, wedding funds, maternity leave funds, etc. Basically, anything that you want to save for that is a ways out, that costs a nice chunk of change (say anything more than 2-3 months of salary), and that accords with your values should fall here.
Mid term goals often require a bit of guesswork both on amounts and timing. In practice, you're likely to shift money from one mid term goal to another whenever an important life event intervenes. That's no problem, the point of defining these goals is to help you determine what to do with your money next.
Long Term Goals:
Life Reason: We're likely to outlive our ability to work, and don't wish to burden our children with the cost of our care. Ideally, we would like to leave property that could be an inheritance or given to causes we love.
Terminal Amount: $1.5M indexed to inflation
When goal needs to be met: 2050
The only three goals that should be considered long term goals are long term care funds (for example, if you've got a disabled child who will need financial help even after you die), retirement, and charitable gifts in perpetuity (setting up an endowment for a cause you believe in).
How to create minimum payments:
Once you've established your goals, you need to create minimum "payments" for each of them. How much will you pay yourself each month in service of these goals?
When it comes to retirement, think of your minimum payment the way you think of a mortgage payment. It's big. Although you could be very scientific about this, I recommend that people under 40 save 15% of your gross income (remember favorite younger sister, the value of your housing should be included as part of your gross income). If you're over 40, and you have no investments of note (less than $100K), then you're playing catch up and you should consider your minimum payment 20% of your income. I recommend using retirement savings vehicles (especially a company 401K with a match for these).
Minimum payments for mid-term goals are the most difficult. Logically, you would think that you should divide the amount required (less what you've got saved already) by the time you have remaining to meet the goal, and call that your minimum payment. However, the reality of the situation is that most mid-term goals have a certain element of "maybe" built into them.
If you, like me, basically guessed at both the amounts and the timing, I recommend taking another approach. Save or invest enough that your goal feels prioritized, but less than the amount required to meet your goal.
For example, for our kids college funds, we're setting aside a minimum of $2K annually. This logically gets us to about 37% of our goal plus the hope for some market ROI which gets us closer to 60%. Where's the rest of the money going to come from? I don't know, we'll deal with that when the time comes.
For our house, we set aside just $100 per month. We're never going to get to $275K by 2030 with that kind of savings, but we might sell some assets to obtain the house, or do some of the work ourselves, or... When we get closer to actually wanting to build that house, we'll figure out what we need to do to make it happen.
Likewise the sabbatical fund receives $100 per month. Again, this is just enough for us to feel that in the future if we want to exercise this option that we'll have a great starting place, and then we can focus intensely on beefing up the funds to where they need to be.
Since short term goals happen within the year, the minimum payments of the amount required divided by the time you have to get there.
For our E-Fund we need $0. Our baby fund is fully stocked, but let's say we needed an additional $1200 by March, then we would set aside $400 a month minimum.
Can you meet your minimum monthly obligations?
Once you define all your monthly payments, add them up.
Let's say the total is $2500. Can you find at least $2500 in your budget each month to meet these goals? If not, then you need to adjust two things:
1. Your minimum goal payment.
2. The number of goals receiving funding.
Do you want to have a vacation fund and a car fund? Do you really want to buy a nicer house someday? Is a sabbatical necessary? Cut the number of goals receiving funding and the minimum payments (except retirement funding) until you have achieved minimum payments that you can meet.
Now start the snowball rolling:
When you first start investing and saving you may not have a ton of breathing room in your budget. That's fine, the point isn't that the investing snowball makes you rich right away. Instead, it gives you the opportunity to direct your money better.
Using my personal examples, this is how we would direct our money:
1. Regular spending and giving.
2. Defined "minimum payments" to each goal (put money in Tax advantaged investments if possible. For example, our medical goals receive funding in an HSA. Our retirement goals go in a 401K and Roth IRAs. Our education goals go into an ESA (though 529s are probably better), and other goals go into high yield savings accounts or after-tax investment accounts).
3. Any extra money goes to the short term goal with the nearest deadline. If that means refueling our e-fund, that's where it goes. If that means the baby fund, that's where it goes. EVERY SINGLE EXTRA DOLLAR goes to the goal that you want to achieve soonest. No extra money goes to retirement or sabbaticals or anything else until we've filled the baby fund.
4. Once you've fully met the terminal amount, direct every single dollar to the next nearest goal. This means the $400 we were directing to the baby fund can go to the sabbatical fund.
5. Continue investing, but you are allowed to add and remove goals as you see fit. For example, eventually we will add car fund to our short term goals.
Why the snowball works!
Building wealth is one of the most personal parts of personal finance, and it's incredibly personal because math can tell you the best way to get a lot of money, but only you can tell yourself how to use the money.
The investing snowball works because it will help you direct most of your money (and energy) towards your most important and most urgent goal without neglecting other important goals. The investing snowball harnesses the emotional energy associated with accomplishing goals without pre-defining what goal has to be the most important to you.
The investing snowball won't help you achieve super-early retirement, nor will it help you become rich super-quickly, but it's a great way to stay on top of your goals and build wealth in a way that matters to you.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.