Monday, September 28, 2009

In Your 20s - What to do with your savings?

So you're in your twenties. You've been on holidays, had some fun and now you've got some savings. You've got no idea what to do with your money or what you need to learn or think about. You've heard about the scams, you're wary about where you put your hard earned savings. You want to invest but you really haven't got a clue about where to start. Or maybe you have some idea but hesitation and lack of confidence is the culprit for your inaction.

It's great that you have savings and have either no debt or minimal debt (which is managed and the credit cards are paid off in entirety before interest is incurred). It really is the best place to be in your twenties. You've given yourself a head start and can easily, with some planning, be a millionaire simply by regularly continuing to save and invest. It really is that simple. There is no secret to becoming a millionaire.

Most people will earn between one to a few millions over their working life. Virtually anyone could be a millionaire. The only ones who will be millionaires are the ones who are intelligent enough to realise that they need to save and invest regularly and the earlier the better!

It's a bit of a conundrum to be a twenty something year old. On one hand, you want the lifestyle, the partying, the holidays and exotic overseas trips, the experiences and the desires for toys, whether it be fast cars, electronic gadgets, or high end, luxury brand shoes, handbags and accessories. On the other hand, you know you've got to start saving for a deposit to buy place of your own, you maybe be already renting or thinking about moving out and buying furniture, maybe you would like to get married and have some kids in your future. Obviously you will need to balance your needs and desires with your financial goals.

Asset allocation. This is probably one of the trickiest thing you will ever have to learn in terms of managing your money. It concerns how you split your money and what you invest in. Your asset allocation should change as you get older. Generally, it can be broken up into five main categories: cash, fixed interest, property, shares (international vs domestic) and Retirement/Superannuation accounts.

Cash is simple to understand - you either have it in your bank account or you don't. Fixed interest - bonds, term deposits and anything that is paying a fixed interest/return/yield. The next two, property and shares are considered riskier. Mainly because the value of real estate and shares are volatile and subject to fluctuation. Retirement/Superannuation accounts are a class of their own, and depending on how you allocate those funds, can be as risk-free or as risky as you desire.

How should you allocate? In your twenties, you're still young, still got plans to get married, have kids, travel and party. Last thing you want is to lock away all your funds in a retirement account. If you're in the marginal tax bracket and wish to sacrifice some salary into your super account - then by all means go for it, but make sure that you've taken into account, your future needs and expenditures. Once it's placed into super, it's no longer possible for you to withdraw it without qualifying for hardship or early withdrawal reasons - you really don't want to qualify for this category anyway...if you ever do, you know you're close to living under the bridge in a cardboard box.

Think about what you need to buy and your future expenditures. Anything that is short term (less than 2-3 years away) you might want to place the bulk of these funds into a high interest online savings account or a term deposit. If you have worked out that you have funds left over for investing, after taking into account your future monetary requirements, then you could start investing either directly into shares, buying properties or investing into managed funds. When buying into shares and properties, a general rule of thumb is that you need to invest for at least a minimum of three years and greater.

Your asset allocation will also depend on your own 'risk profile.' You should learn about what 'risk profile' means and where abouts you fall in the risk spectrum. I am writing to address readers who fall into the medium risk profile, not too averse and not too risk taking.

To start you off, I will illustrate how my own funds were allocated and their priorities:

1) Emergency Fund (EF)- 3-6 months minimum that pays for living expenses and bills. This is also determined by how long it would take you to find a replacement job if you lost your job. To be technical, I don't have an EF fund per se myself but I consider all my liquid investments (investments that are easily converted to cash) as part of my EF.

2) Deposit for property - 20% target, this amount is parked in a high interest savings account with the EF, if you need to segregate your funds, then by all means do it but I don't need multiple accounts to manage my finances

3) Investments (if this exceeds 20-30% of your total savings, you are venturing onto riskier territory and a riskier profile) - while you are busy saving the deposit for your property, it's good to start testing the investment waters with $500-$5,000 in shares/stocks/managed funds/REITs/ETFs etc. By using your money, you will learn a lot faster and motivate yourself. See an financial planner or have an investment adviser if you are inexperienced. Otherwise, take the time to learn how to invest directly if you prefer the DIY method.

If you're saavy, then go ahead, go all out and invest 90-100% of your savings. It's a volatile road and you may win a lot or lose a lot but it's something you need to reconcile with yourself in terms of your risk profile.

Insurance. Alright there's a multitude of insurance options out there. You're a twenty something and you're just starting out. Health insurance is one of the best thing you could ever buy for yourself. If anything happens, this ensures that you aren't hit with a hospital bill for tens of thousands of dollars. Car insurance/third party insurance (insuring the cars that you may crash into) is important as well, especially if you've bought a car on a loan or have a car that isn't easy to replace if you had an accident with it.

What about the other insurances? Income protection, TPD (Total Permanent Disability), Trauma Insurance and Life Insurance? One of the most important insurance is income protection, particularly when you've got a mortgage or loans to pay. If you injure yourself, income protection should help to restore a portion of your original income. If you've got dependents already(wife, husband or kids), life insurance is important because if anything happened to you as the bread winner, then the life insurance payout will pay out a lump sum figure that may help with settling your liabilities and loans.

TPD and Truama Insurance, it's really a hit and miss. It's always good to have all your insurance bases covered but this will cost you a lot of money. It's up to you whether you wish to insure yourself against all problems and detrimental possibilities. Health, car, income protection and life insurance is a good place to start.

Pay yourself first, not just 10% but make it 40%. Why should you pay the companies by spending all your money on goods and leave none for yourself? In hard times, you only have yourself to rely on. So by paying yourself first, you can build up emergency funds (EF) and passive income which can support you if you lose your job or anything happened to you and you can't earn income directly from your labour.

10% is a commonly quoted percentage. 40% is much better. Saving $200/month is lame. You want to be saving at least $1,500/month and more. If you are on a low income, you can either cut expenses further or look for ways you can increase your income. Even saving $5 a week is a good start if you're hopeless. What you need is to develop the habit and it will soon be effortless. But why am I harping on about this right? Afterall this article I'm writing is focused on the fact that you've got some savings already!

I'm just hammering in the point that you can save a greater percentage or earn more and it will expedite the size of your investment portfolio/savings a lot quicker.

To illustrate using an simple scenario, assume you have $100,000 in savings, yielding(earning) 10% pa simple interest. That equates to $10,000 in investment income. If you left your investment alone to reinvest and compound, then at the end of year two, the $110,000 would grow to $121,000, earning $11,000 in the second year without you doing anything! That's the beauty of compound interest.

Now if I changed the scenario in year one to have you save $10,000 on top, you've got a total of $20,000 which would have taken your original investment almost two years to earn. At the end of year one, you now have $120,000 yielding 10% pa simple interest, equating to $12,000 passive income. At the end of the second year, your balance would be $132,000. Once again, compound interest is working just like a steroid on your savings/investment.

There's a multitude of ways you can allocate your money for spending, saving and investing. It's very important to understand your risk profile and to consider what your future short term expenditure will be so that you don't mismatch your asset allocation with your needs. I hope that you've learnt something from this and that it may serve you well on your investment journey or otherwise help you understand the financial side of life a bit better, while you're in your twenties.

The best time to plan anything is in your twenties. Don't forget to have some fun along the way :)

1 comment:

  1. I wrote about this one - in far less depth.

    A few of the easiest ways to save money:

    - Dont smoke. Then pretend you did and put about $5 or $10 a day aside as "smoking money". Save it.

    - Make your own lunch and take it to work. You can save between $3 and $6 per day doing this, which does not sound like much but with 220 working days in a year, this is between about $600 and $1300 saved at little of no great loss of lifestyle.

    Blowing the above savings on a weekly trip to the pub blowing $100 on drinks is not a good way to use what you saved! Saving means putting the money away. Then make it grow.