How Much Should I Invest?
This edition, as we approach Christmas; the end of one year and the beginning of the next, we asked our resident columnist Robert MacDonald CFP about one of the things many reflect on at this time in relation to our money and our life… Do I have enough to allow me to continue my current lifestyle, am I saving/investing enough to have the lifestyle I desire when I retire? Clearly a very important aspect of this is how much to invest. Here Robert looks at some of the simple but often overlooked aspects to be mindful of.
You might think that the single most important investment decision you have to make is what share or fund you should invest in and I would agree that this is a pretty important question. But it’s equally important (if not more so) to know how much to invest and here’s why.
You might select the best investment possible, but if you don’t invest enough it won’t matter. Clearly the percentage return will be great but if you invest only a small amount of what you could, you are ignoring opportunity and it could be a huge one!
And the opposite is also true. If you invest too much, you could find yourself in a precarious financial situation before you know it. People who invest too much often don’t have enough liquid cash to cover short-term needs and emergency situations as they pop up. When they hit a bump in the road, they either have to sell out of their investments at an inappropriate time or unfortunately have to borrow. Either way, it’s not exactly a comforting place to be in…
How to Find the Right Balance
Some people make this very complicated. But keeping things as simple as possible is always a good option. Simply put, work out how much short term capital/income you may need and then you can get a greater sense of how much you can invest. You can do that just by asking yourself a few questions:
- Emergency Fund
You really can’t invest your emergency cash so the first question to ask is, how much do you need? That may seem like a very difficult question to answer because you can’t predict the future.
While it’s true that you can’t ever know what’s going to happen in the future, you can make a reasonably informed guess about how much cash you need to keep available for instant needs. One way you can do this is by thinking about the worst financial crisis you’ve had to deal with over the last 10 years. In my experience, that’s a good gauge of what you might need for emergencies in the future.
This isn’t a guarantee and clearly not very scientific either but it’s a reasonable start. Think about your own situation over the last decade. Let’s say the worst financial disaster you had to deal with cost you £20,000 five years ago. You may think with inflation that could be £25,000 and whilst it’s possible that you might need this for an emergency down the line, it’s not very likely. So for this example let’s put aside £10,000.
- Monthly Spending
The next question to ask yourself is how much you need to live on each month and how stable your income sources are. There are a variety of ways to calculate your average spending but my favourite method is to let my bank statements tell me. It only takes about 5 minutes a month to figure this out and it is a far more accurate measurement than other approaches that take hours each week.
Next, consider how stable your income is. When people tell me their jobs are very stable, I suggest that they still keep 3-6 month’s salary available anyway. If their incomes are volatile or self-employed and don’t have the luxury of a sick pay scheme, I suggest they keep 6 to 12 month’s salary tucked away. On the other hand, if all your income comes from pensions and reliable investment income, you might need even less cash lying around.
For our purposes, let’s say you need £2,000 a month to live on and you have a very stable job. Using the formula above, you would earmark another £6,000 for an “income emergency”.
- Foreseeable Expenses
The last question you need to answer before knowing how much to invest is to ask yourself if you’ll need a large amount of cash over the next 1 to 2 years. For example, if you know you’re going to need cash for a home purchase, new car or whatever, you really shouldn’t invest that money. Again, you won’t earn much interest on that money but it just doesn’t matter. You can’t take any chances. Think about what might happen if you invest it and then need that cash later on. If you need to sell at a time when the market is down it could derail your plans to buy the house, car or other major item. For our example, let’s say you don’t have any large outlays on the horizon. At this point, it’s pretty easy to figure out how much you can invest. You already know that you might need about say £16,000 (£10,000 plus 3 X £2,000 monthy income) for emergencies. So that means you should invest everything above that amount. Simplicity itself.
As a further refinement, think about how much money you might need in 2–5 years, 5–10 and 10 and beyond. A simple way to deal with this is to have each chunk of money you require invested in a different strategy because the closer it is to the time you absolutely need the money, the more conservatively you should invest it. Whilst nothing in life is certain (other than death and taxes!), a more accurate way to understand how much is required is to go through life is to use a process called “cash-flow analysis” or “cash-flow modelling” and this looks at your expected income and expenditure (ongoing/one off/recurring) inflated accordingly to keep pace with the rise in costs of things. All good financial planners should do this.
Knowing how much to invest may not be as difficult as you think, just be very clear on how much you should hold back for your expenditure, short term and emergency needs and let what is left over work for you. And remember what arguably the most prolific investor on the planet Warren Buffet maintains when asked of the two most important investment decisions in life, “Marry well… and… never leave ALL your money in cash” – wise words indeed from the oracle of Omaha !
The views in this article are personal and provided for informational purposes only and should not be construed as
recommendation by the publisher or investment advice by the contributor as laid down by the Financial Conduct authority.