Getting to grip with debt, budgeting, and emergency funds
The aim is to grow your wealth over the medium and long term – and you’ll no doubt want to give yourself the best chance possible of success. That means starting out by minimizing the amount of pesky interest payments you’ve got on any outstanding debts – since those payments erode any gains you might earn from savings or investments.
Debt often gets a bad rap – but arguably, not all of it is deserved. Some debt can actually be good. Stick with us…
Good debt is that which provides a financial benefit over and above the money and leaves you better off overall. For example, once a mortgage is repaid, you’ll be the sole owner of a property which may increase in value – and even before then, you can potentially generate rental income. Student loans are likely good debt too, since higher education should boost your job prospects and earnings potential.
Bad debt, on the other hand, is all take and no give – it doesn’t provide any future financial benefit. Tomorrow you won’t thank today you for the financial fallout of debt-fueled shopping sprees, luxury holidays, or using credit to pay off bills.
One way to defeat pricey bad debt is to transfer your outstanding credit card balances. Although there are often initial fees involved, many credit cards allow you to move existing debt to a new card interest-free (for a while). That should help you pay off your balance more easily – but be careful not to add to it, as you’ll probably still be charged interest on new purchases.
For larger or longer-term debts, consolidation might help. By taking out a single new loan and using that money to pay off all your other loans, you may be able to reduce your interest costs and, again, pay off your balance faster.
Once your debts are under control, it’s important to protect yourself (and your wealth) from life’s unexpected trials and tribs. Introducing the emergency fund…
An emergency fund is money you set aside to cushion unexpected financial shocks that can be stressful as well as expensive: losing your phone, your job – or even a few teeth. A good rule of thumb is that you should have three months’ salary after tax set aside to help weather the storm during life’s more testing tempests.
Sadly, the average Brit has less than one month’s salary set aside for a rainy day. This can easily lead to rising debt (of the bad kind), because when a financial emergency strikes, you’ll be forced to borrow – ultimately increasing your financial burden thanks to interest payments, and hampering your saving and investing goals.
If you don’t already have one, you can start building up your emergency fund right now. Putting aside just £100 a month soon adds up. It may make sense to store your emergency cash in a savings account with “instant access”, meaning you can get hold of it quickly in an emergency – while also earning a little interest.
It sounds a bit dry; but in order to figure out how much you’re able to invest, you’ll need to keep track of your regular incomings and outgoings to know how much cash you’ve got available now – and how much you expect to have available on a monthly basis.
You can go retro with the trusty combination of pen and paper or use a spreadsheet – but no matter what your preferred budgeting tool, here’s one bit of handy advice championed by none other than the “Oracle of Omaha” himself, billionaire investor Warren Buffett…
Pay yourself first. Putting money from your paycheck directly into a savings or investment account before paying for anything else hopefully means that money out of sight is also out of mind – and therefore is less likely to be spent on a whim. Do, of course, leave enough to cover your necessary expenses...
Five questions to consider
You’ve wrestled with the angel of debts, built up a buffer, and identified the slack in your budgetary sack. Nice. But before you start looking at providers or portfolios, you’ll need to have your answer to the investment equation ready. To get there, consider these five things:
If you were to squirrel away a chunk of change for three to five years, how much would you be able to put aside today? When saving or investing for the long term, this is an important question to answer – it’s your starting pot of money. You could invest it all in one go, or slowly over time. But more on that later…
If you had to put another chunk of cash away – but this time from your monthly income – how much could you afford to save or invest? It’s worth being conservative in your assessment: this is money you shouldn’t expect to see again for three years at the earliest.
What’s your saving or investing goal? If it’s specific, is there an amount of money at which you plan to cash out? Be clear about what that is and why. But you don’t have to have a set aim right now; building up smallish annual gains into something rather impressive while preventing inflation from eroding the value of your money is a noble goal in itself.
Three to five years is a good minimum when it comes to saving or investing. If you’re in more of a hurry – perhaps because you’re saving towards a house deposit – it’s worth bearing in mind that this may limit the ways in which it makes sense for you to invest and save: specifically, the level of risk you should be willing to take. On the other hand, if you’re putting money aside for the very long term, like for retirement, then you can probably take more risk now – since there’s lots more time in which to make up any short-term losses.
Following on from the above, remember higher risk means potentially higher rewards – but it also opens the door to higher potential losses. Even if you’re investing over the long term, if the idea of high risk turns your stomach, you’re perfectly entitled to seek safer havens. After all, you don’t want to find yourself selling off your investments in a panic if they drop by more than you were prepared for. Your risk tolerance may also change depending on your other investments. If you use a robo-advisor, for example, your overall risk level may end up higher or lower than you’d like – check out why.
Once you’ve got answers to these five questions, you’ll be in a pretty good place. You should have a good understanding of how much you’re able to invest or save, which will help you make more informed, empowered choices about which approaches and providers might suit you best.
Of course, these questions don’t exist in a vacuum – they all impact one another. For example, if you’re starting out with £1,000, can contribute an extra £200 a month, and have a target amount of £30,000, you’ll either need a long time horizon, a willingness to take on a lot of risk – or both.
The joy of this investment equation is that you don’t actually need to answer every question. If you’ve got firm answers to any four, the fifth answers itself. Using the above example, if your aim was to achieve your target in six years, the average annual return required to get you there would mean you’d have to accept much higher risk – or alternatively change your answer to another question, like how much you were putting in regularly.
All at once, or over time?
Once you’re happy you know how much money you’ve got ready to put to work – and once the investment equation’s helped you set and refine your expectations – it’s time to get spending. If your cash is headed into a savings account, there’s probably nothing stopping you putting all your money in at once – so go right ahead. If you’re investing it, on the other hand, it’s worth considering your options.
Some evidence suggests that buying into the market in one go usually leads to a better performance than averaging in over time, since the value of stocks tends to go up in most years (but not in all). It may also better suit investors with a longer time horizon, who’re more likely to have enough time to recover from any temporary downward market dips.
Another potential benefit of investing all at once is lower transaction fees. Depending on your provider, you may have to pay both a fixed fee and a percentage of the amount you’re investing on each occasion. Investing a large chunk at once may therefore lower your overall fees.
On the other hand, investing all at once comes with some timing risk. You might buy at a low point – a.k.a. “buy the dip” – and potentially loc in higher future profit than you otherwise might. But you might equally pile in right before a major drop in prices – and spend an uncomfortable period seeing your investment in the red. Remember, even the pros find it hard to “time the market”...
Those new to investing may understandably find the prospect of investing a large amount of money in one fell swoop rather daunting. In order to decrease the risk of buying stocks at the wrong time, some investors employ a technique called “dollar-cost averaging” (that’s pound-cost averaging to Brits). This involves committing to invest a fixed amount on a regular schedule (e.g. monthly). After a period of time – say 18 months – you’ll have invested all the money you planned to, having essentially paid the “average” price of your chosen investments over that time.
One of the benefits here is that you inherently purchase more, say, stocks when prices go down and fewer stocks when prices go up, given that you’re investing the same amount each month. (£100 invested in stocks priced at £10 each buys more stocks than £100 invested in stocks priced at £15.) This approach may therefore suit investors who want to smooth out the initial risk of buying investments.
But on the downside, you’ll probably pay higher fees over time than you would investing in one go. Furthermore, while you’re waiting to invest the rest of your money, it’s not earning much of a return – and nor is it benefiting from the all-important compounding effect, lowering your potential future gains.
Of course, you don’t need to live or die by the initial approach you choose here. You can invest a larger amount upfront and then continue adding to it at regular intervals over time.