A difficult question that many people on their mission to financial independence quickly encounter is “where they should get their money to work for them”: You’ve managed to cut down a little on your expenses, or to up your income or earnings from a side hustle. But the question as to what to do with the extra money you now have remains. Let’s review some of the avenues on how to “make money with your money” that we have looked at on this mission:
- Paying off debt – saves you money on interest and compounded interested paid over the years.
- Saving – generates money due to interest received and the power of compounding interest over the years.
- Investing – generates money due to capital gains, interest received or dividends.
- Pensions – builds up the income you’ll receive after your retirement age
- Personal capital – increases your earning potential as a professional or entrepreneur.
These are the most common strategies to pursue in order to leverage what your money can do for you.
But where to start? Say you saved $100 this month and that you are happy to invest this money into your future and future earnings, where do you actually put this money? Which of the above options do you choose? And how do you mix these strategies?
If you haven’t yet fully read the previous steps on the above mentioned strategies, I invite you to read those first before continuing reading this step, to better understand all the pros and cons of each strategy. Just come back once you’re done!
The question of where to allocate your money doesn’t have to imply an “either …or…” situation. You can start investing whilst still having a mortgage. You’ll want to save an emergency fund together whilst still paying off credit card debt. And once you start investing in your personal capital, you’ll likely want to keep that up on a fairly regular basis and the fact that you are investing in the market doesn’t rule out this option.
That said, some people feel more comfortable paying off all their debt first or hitting a specific savings goal before starting to invest in the market. As always it is important to do what you feel most comfortable with and what seems most logical for your personal situation.
Below are tips and guidelines that you can use and adapt in order to put your own specific money allocation strategy together:
- Debt payments
- Based on the annual interest rates of your various debt, prioritize any debt over a certain percentage. A good guideline is to attack any debt with an annual interest rate over 5% – 6%. The compounding effects of these debts make them a very expensive business and especially credit card debt can have high interest rates of around 15% or more. Consider giving paying off these debts an absolute priority.
- Apart from the above, your opinion about debt might be very important too. If you feel uncomfortable about owing money to somebody else, prioritize paying off debt over anything else.
- this can greatly depend on your job stability and how variable your income is. If your job stability is relatively high and you have a sufficient guaranteed monthly income, then you might not need to get a 6 months living fund together as quickly as somebody whose job is less secure or whose income varies greatly from one month to the next.
- Your savings goals can further determine whether you should allocate more or less to your savings. Are they short-term goals or long-term ones? Do you feel comfortable with keeping a 6-12 month living fund in your savings account and investing everything else, or do you want (or need) more money in a savings account?
- Lastly the interest rate on your savings can further determine whether to adjust your savings goals. At the time of writing some banks at Europe have an interest rate of 0% or even a negative rate, meaning customers pay to store their money with a bank. During times like this it might be more interesting to invest more, at least until interest rates go up again. Especially if the interest rate is far below the rate of inflation, money quickly looses its value, whereas when interest rates are above inflation, money in a savings account can be a lot more interesting.
- Consider your return on investments, i.e. what will be your expected returns. High or low markets of course affect the expected returns, and if a savings account isn’t giving you much return, you might want to give investing more priority for a while.
- The possible risks of losing a lot of the value of money that is invested might make paying off debt far more interesting at first before you start investing more as your money might give you a lot more when paying off debt.
- if your employer matches your pension contributions, it is often interesting to max out your pension and contribute as much as you can, at least if your pension is based on cheap index accounts, not on expensive mutual funds.
- If you have tax advantage accounts then putting extra money towards these should again get more priority.
- Personal Capital
- Investing in your personal capital, even in training programmes that are priced higher than self-help books, might deserve priority at times when the expected outcomes or returns of the programme are far bigger than other strategies might give you and if the course fits in perfectly with what you are looking for. The offer of online courses is growing rapidly and more are being launched every week. Whether you invest in an online course, a book or another college degree, nowadays you pretty much find a course for anything you might need.
Plan your strategy
Based on the above an example linear strategy in which you complete each step before moving on to the next one, could be:
- Save for a $1,000 emergency fund.
- Become debt free
- Pay off mortgage
- Save a 6 months living fund together
- Max out pension contributions
- Start investing
If you want to go for a more customized strategy, an example strategy could be:
- Save for a $1,000 emergency fund.
- Aggressively pay off any debt over 5-6% annual interest rates
- Put together your own plan of a proportional money allocation strategy, for example: Saving / Investing / Pension contributions / Personal capital growth / Debt payments.
- If you want to get rid of any debt as soon as possible, your contributions might look like: 0/0/0/0/100%
- Alternatively you might want to put money towards all of these areas but in different proportions, such as 10% / 50% / 10% / 5% / 25% for an aggressive investment strategy or 20% / 20% / 25% / 5% / 30% for a more balanced approach.
- Over time you adjust your strategy as you reach your various targets or your situation changes. You don’t always have to stick with the same percentages, once you pay off your debt, you free up money that can go elsewhere. Similarly factors such as a higher or lower income or market returns can affect where you can and want to put less or extra money.
Step 86 – How to Prioritize Money Strategies – in detail:
- First of all determine your feelings about debt and your risk levels in terms of saving and investing. How bad is debt for you and how badly do you want to get rid of it? Would you feel comfortable to start investing even if you still have debt? How big are your savings goals? Do you feel comfortable having a big chunk of money in the market or would you rather first have a substantial amount of saving built up?
- Make a list of all the various money allocation strategies you want to pursue and put them in a logical order as per the examples above. What is your target number 1 that you will stick to before starting any of the other targets until you’ve completed it? What about number two? How many targets do you want to complete first before starting a divided money strategy in which you assign parts of the extra money to various targets?
- Review your list and make sure you feel absolutely confident and happy about it. If you want you can assign target dates to it.
- Review your list annually during your yearly finance review, make any changes as needed depending on circumstances that might have changed.
Don’t see the above list as set in stone. As you situation changes, your pay increases or decreases, interest rates change and Wall Street experiencing a bear or bull market, you will want to modify your plan too. But having a flexible plan that you constantly mold to your needs is better than not having a plan at all. It will help you when setting your budget and building your secure financial future. Happy planning!
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.