Under normal circumstances you should not seriously consider investing, and certainly not in the stock market, unless you satisfy at least one of the three following conditions:
- You have at least one year's income deposited in a bank, or in some other liquid form of savings.
- Your current assets equal or exceed twice your current liabilities.
- You have just acquired a sudden windfall or inheritance, which should be thought of as capital and not as current income.
Some observers suggest that it is already too late if you wait to meet these criteria. They would urge you to start an active investment program side by side with an active savings program. Indeed, they view both as part and parcel of modern money management techniques. Perhaps this is true, but, realistically, most people are not psychologically ready to invest until they feel financially secure. And security for most people is money in the bank.
How much cash or cash equivalent should you keep on hand?
While there can never be too much of a good thing, excessive cash or cash equivalent (money market mutual fund shares; Treasury bills, etc.) indicates that it could be put to more productive use. Have sufficient cash to cover three months' living expenses.
How is your cash or cash equivalent employed?
An incredible amount of funds are left in savings accounts earning minimum interest though financial markets now offer a variety of accounts that produce more than basic passbook interest. Thus, it is possible to receive higher yields within the same insured bank. When possible, cash savings should be deposited in a money market bank account or money market mutual fund to capture market-driven interest rates. Commit to saving 5 per cent of your annual earnings: $25,000 requires placing $1,250 into savings and $50,000 means $2,500. This is a high percentage to save, and some individuals may be able to save only 5 per cent of disposable income, that is, after they have paid their bills.
How fast should your assets grow?
Individuals should protect themselves by putting in place a mandatory saving and investment plan. Theoretically, it would be nice to see net assets increase by 10 per cent a year. The first step is to save at least 5 per cent of your total income, or at least 5 per cent of your disposable income.
There are no hard-and-fast rules about saving -- it certainly depends on your personal economic conditions, your temperament and of course the unsuspected demands that inevitably arise. How much you save depends on your age, family situation (or lack of it) and your path. If you are paying off student loans for five or ten years after college or graduate school, your net worth is not likely to increase rapidly, if at all. And certainly a new family and a new home, both items of great cost, are likely to keep your accumulation curve relatively flat.
In the final analysis, how much you save depends on how much you earn, and that of course changes throughout life. Nevertheless, it is important to establish a regular savings habit for your own financial health. Savings are initially the basic component of your total assets. After a number of years your assets will grow from the interest on your savings and the growth of your investments.
If your savings grow at no less than 5 per cent a year, how fast will your assets grow? That of course depends on the rate of interest paid on savings, both for short-term and long-term deposits. As a rule, a 10 per cent annual increase of net worth might reasonably be expected -- half based on new savings and the other half based on interest on previous savings (approximately 5 percent), as well as the paydown on mortgages and other asset-building debts.
Savings patterns
The Greeks thought there were three distinct phases of a person's life, the great Asian religious leaders thought there were four, and Shakespeare suggested seven stages of life. Today one's life-span is longer, career and work experiences are more varied, educational requirements are extended and marital life is uncertain, with frequent second marriages. All these factors increase the number of stages experienced in life. Varied life-styles indicate that people choose some stages, but not others. Therefore, the situations that follow are meant to show some possible savings alternatives, but they are not mandatory progressions. You pay your money and you make your choices -- nothing is written in stone and there are no "correct" ways of saving.
There are examples of savings plans that are designed to provide you with the highest return and maximum flexibility. Be aware that there is a trade-off between the two. Institutions such as banks and savings and loan companies pay the highest interest for money that they can in turn commit for long periods to their borrowers.
However, it is disastrous in the banking business to lend funds on a long-term basis and borrow them from depositors on a short-term basis. Bankers try to avoid this dilemma by promising not only to pay more for long-term funds but to penalize depositors who remove their funds before maturity or due dates. Thus, place your funds in long-term time deposits to obtain the best rates of interest -- often 2, 3 or 4 percent more than the rates provided for short-term deposits. There are times when short-term interest rates may be higher than long-term ones. This inversion of yields is relatively rare and savers cannot easily take advantage of it. However, investors in the fixed-income market and bonds should be aware of this condition to make a profit.
On the other hand, you need short-term savings for specific calls on your money whether to meet medical emergencies, educational payments, vacation trips, car payments, moving expenses and all the other frequent planned and unplanned expenses of living. At a minimum you should keep 12 weeks' reserve (of your ordinary expenses) of cash in short-term savings before committing funds to longer-term accounts. Finally, everyone needs transaction funds -- money you do not expect to sit in a bank for more than a few weeks, or until you get around to paying routine bills.
Excerpt from The Basics of Investing by Gerald Krefetz.
Gerald Krefetz is a principal of Krefetz Management and Research, he runs a private money management service for individuals in Manhattan, USA and has written more than twelve books.
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