Sound Investing 1: Saving

Live within your means

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The first principle of sound investing is easy to state, but harder to follow. Unless you are independently wealthy, you have to save in order to have money to invest, and that requires you to live within your means. Many households find that difficult, either because of their low incomes or their lifestyle choices. For much of the twentieth century, households carried little consumer debt and saved about 7-10% of their disposable incomes. Between the mid-1980s and the crash of 2008, consumer debt soared and the savings rate fell to near zero. (And if you consider the national debt and the international balance of payments deficit, it appears that the whole country has been trying to live beyond its means, with a lot of help from capital exporters like China.)

Years ago, the banking industry would help people live within their means by lending them only as much money as they could reasonably be expected to repay. But then a series of legal and regulatory changes greatly increased the interest rates that banks are permitted to charge. Now banks can profit from loans to customers whose ability to repay the principal is questionable, but who can be induced to pay interest for a very long time. By aggressively pushing high-interest loans, the banks have enabled millions of Americans to live beyond their means. At the same time they have successfully lobbied for more restrictive bankruptcy laws to make it harder for those who go broke to discharge their debts. If the words “pushing” and “enabling” make credit card debt sound like a form of addiction, perhaps the analogy is useful. The advice it suggests seems appropriate: Know your limit. Don’t rely on the bartender or the other drinkers to tell you when to stop. Stop spending well before you use up all your income, even if powerful voices in society tell you to keep the party going.

Vicious and virtuous circles

The balance you strike between income and expenditures is a choice between a vicious circle and a virtuous circle, or if you like, a downward financial spiral and an upward financial spiral. The more you borrow, the more you have to spend on finance charges, and so the less you can invest, and so the less you accumulate for future spending, and so the more you have to borrow . . . and so on, until you are facing a bleak financial future. But the more you save, the more you can invest, and so the more you earn on your investments, and so the more you can reinvest . . . and so on, until you have achieved financial security. Only if you can get into this virtuous financial circle can the other principles of investment be of much use to you.

Pay yourself first

A popular slogan with financial advisors is “Pay yourself first.” If you can take a percentage of your income right off the top and put it away in savings, you will greatly improve your chances of achieving your long-term financial goals. Investing through a payroll deduction plan is an excellent way to do this.

How much should you save? For retirement savings, a very general guideline is 10 to 15 percent of income. The higher the savings rate, the higher the “replacement rate,” the proportion of your working income that you can replace with investment income after you retire. The next section will discuss this in more detail. In addition, you may want to save and invest for short-term or intermediate-term goals like college education. Financial advisors also recommend an emergency fund equivalent to at least three months of income (or better, six months) that is held in cash.

As you get older, the percentage you need to save depends on how much you’ve saved already. T. Rowe Price recommends that a 40-year-old with existing savings equal to two times annual salary should save 12% a year for retirement. The recommended savings rate drops to as little as 5% with existing savings three times salary, and goes as high as 25% with no existing savings at all.

The single best thing you can do to improve your investment returns is to increase your regular contributions to your investment accounts. Research has found that this is generally more effective than changing your asset allocation or switching from one mutual fund to another. Those other kinds of decisions have their place, and they will be addressed in later posts. But be sure to put first things first.

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