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What Percentage of Your Income Should You Invest?

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What Percentage of Your Income Should You Invest?

Authored by: J. Froentjes
Last updated: 22 July 2022

Why is creating an emergency fund the first step to investing?

Emergency funds prevent you from selling your investment when an emergency comes up. Moreover, you’ll have more peace of mind when markets fall, or recessions hit, knowing you have money to last without a job for at least a few months. Therefore, maintaining a balance in your emergency fund that covers at least 3-12 months of your monthly expenses is recommended.

The limitations of an emergency fund

Saving is complex for our brains, and before you start investing, you should try to get your emergency fund in order. Having adequate funds to cover expenses will help you reach your goals and prevent you from selling your investments. However, if you never need to use your emergency fund, you suffer a massive opportunity cost, which is the biggest downside of having an emergency fund. The questions you should ask yourself is: How would I act in terms of investing, knowing I don’t have money to cover emergencies? In some countries, people opt for maximum contribution to their pension plan and don’t maintain an emergency fund, with the idea that they’ll figure it out. Otherwise, they will declare personal bankruptcy. When declaring personal bankruptcy in certain countries, creditors cannot touch your 401k contributions, meaning you’ll be ready for retirement regardless of declaring bankruptcy.

The handbook for budgeting

First and foremost, it is crucial to start by creating a budget. First, you’ll want to make sure you’re analyzing your spending behavior by looking at your bank account, taking a look at all previous expenditures. For example, some individuals are outgoing and spend a lot of money on going out and engaging in social activities. On the other hand, introverts may place more value on staying home or doing something else. The important thing is to be aware of your spending behavior to look for where you can make cuts or where you should be spending more. A popular way of thinking is to overspend on the things you like to do and make dramatic cuts on spending that doesn’t make you happy or is entirely unnecessary.

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While planning your budget, you must remain realistic and think about your goals and whether they reflect what you want to achieve and how you’ll manage to stick to your plan. It can be challenging to stick to your objectives. Unfortunately, long-term investing comes with a price: you’ll live a turbulent life full of unexpected events, expenses, and setbacks. One way to avoid unrealistic goals is to set SMART goals for yourself. First, you’ll have to ensure you set specific goals, meaning you have clearly stated your goal. Second, you must make your goals measurable. After this, you must look at attainability. Are you able to accomplish your goals? You should know all the limitations in the journey to achieving your goals. In addition, pay attention to how realistic your goals are. For example, many investors use 2 percent annual inflation in their projection for wealth growth. As a goal setter, you’ll have to consider whether 2 percent is realistic or outdated. Finally, make your goal time-bound, and set milestones for yourselves to stay motivated. Maybe after a few months or years, you find out your SMART goals are inconsistent and don’t match your lifestyle—life happens. Things will change, and your values and goals will change over time, which you must embrace and constantly adapted to.

If you’ve already figured out how to set goals and track your expenditures, it’s time to look at how you want to allocate certain things in your budget. Budgeting doesn’t only work for discretionary spending, it also helps plan for expected expenses like housing, energy bills, or other expenditures. For example, you might know you will need a new washing machine in a few years, or perhaps you’re sending one of your children to school in the future. These are things you can save for in advance and might seem affect your bank account at the beginning. However, budgeting for expected future purchases can significantly increase the amount of money you’ll have available in the future. Some individuals use automatic allocation or do it themselves.

Using automatic allocation will make it easier for you to allocate funds to your goals. It is a common strategy called paying yourself first. Paying yourself first is an investor attitude and a term used in personal finance and retirement-planning literature that means automatically holding a preset savings contribution from each paycheck when it is received. You are “paying yourself first” since the savings contributions are automatically moved from each paycheck to your savings or investment account. In other words, pay yourself first before paying your monthly living expenses and making discretionary expenditures.

What is the 60/30/10 rule in budgeting?

The 60/30/10 rule in budgeting is a popular way to allocate the money coming into your bank account. With this budget, you’ll put 60 percent of your take-home salary into savings, investments, or debt repayment. Next, you’ll spend 30 percent of your budget on your requirements. These expenses are food, housing, utilities, healthcare, and transportation.

Finally, you allocate 10% of your budget to discretionary expenditures. You could use this money to spend on things you consider guilty pleasures, like going go-karting or buying that newest piece of technology.

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However, it is difficult to follow this rule, and many investors exercise flexibility in implementing it. It could be better as a 50/30/20 rule depending on your situation. Changing the rule to fit your situation can help you design your life according to your needs. For example, perhaps you have less debt you need to pay off, or you want to invest a lower monthly amount throughout your life.

The power of compound interest

Compound interest (or compounding interest) is interest computed on a loan or deposit based on both the initial principal value and the accrued interest from prior periods. Compound interest can cause a sum to increase faster than simple interest, which is computed only on the principal amount.

Compound interest accrues at a rate determined by the frequency of compounding. The higher the number of consecutive compounding periods, the bigger the compound interest. Thus, compound interest on $100,000 compounded at 8 percent annually will be less than compound interest on $100,000 at 4 percent semi-annually over the same period due to the interest-on-interest impact. Compounding has been referred to as the “wonder of compound interest.” As Einstein stated, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it”.

If you’re unfamiliar with compound interest, you may have heard of the rule of 72. The rule of 72 is a simple, helpful rule for estimating the years necessary to double an investment at a given yearly rate of return. It may also calculate the annual rate of compounded return on investment based on how many years it will take to get the same return.

Compound interest is why mutual funds and financial advisors tend to do well since long-term returns are almost guaranteed if your investing period is sufficient. For example, if you decide to invest $10,000 today and lock it away for 40 years against 8 percent, of which your advisor or fund takes 1 percent, you will retire with $295,000. Retiring with this amount sounds excellent. However, if you decided to invest in an ETF without giving up your complete 1 percent, you’d have close to $450,000. So never underestimate the power of compound interest and the effect that investment costs can have on your bottom line.

What is dollar-cost averaging

Dollar-cost averaging (DCA) is an investing method in which an investor distributes the entire amount to be invested over periodic purchases of a target asset to lessen the overall impact of volatility. Investments are frequently made regardless of the asset’s price. Frequent purchases mean that investors will buy either weekly, monthly, or quarterly without showing much emotion regarding stock price.

Recognizing the decision-making risk is the first step in separating emotions from your finances. Next, please acknowledge that you, like all of us, are a herd animal with intense emotional impulses dependent on the people around you. Then admit that your emotions and prejudices are pushing you in the opposite direction of innovative investment ideas.

The pros of dollar-cost averaging

As the name might suggest, you’ll be relatively insensitive to market swings since you’ll be regularly averaging the market by buying consistently over a specific time frame. Dollar-cost averaging may be preferable to purchasing the dip because if you invest a constant amount continuously, you will be more exposed to dips as they occur rather than tracking for a drop. Moreover, when bull markets thrive and you’re waiting for markets to fall, you lose out on all the gains over that period. Some analysts say a recession has been coming for nearly a decade.

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Invest according to your goals

When investing, you must be realistic towards yourself and look at your lifestyle critically. For example, if you like racing cars as a hobby, you’re most likely spending more money than if you were playing basketball. In addition, if you have any plans to have children, you’ll have to adapt your savings plan accordingly. In the United States, it costs $272,049 to sustain a child until their 18th birthday.

Also, take into consideration when and how you want to retire. While it may be hard to think about what your life will look like in the future, it is one of the most crucial steps to establishing reasonable goals. What will your life look like in terms of going out, traveling, and seeing your family?

What is often overlooked is the sacrifice you’re making at the early stages of your life. Investing and paying down debt at 60 percent of your income might require significant sacrifices regarding how you live your life. When you’re young, your income is still low, and you are fit and healthy enough to enjoy whatever you’d like to do. However, your investments grow significantly more if you invest more. Towards age 70, this might make a difference of millions.

Similarly, with dollar-cost averaging, you must stay the course. Like the stock market, you’ll experience the ups and downs of your life, but the most important thing is to stay the course and make it to the end, regardless of what happens.

What kind of retirement suits you?

Early retirement has become increasingly popular over the last couple of years, and more and more young investors are looking for ways to get out of work before they’re close to 70 years old. It is difficult to estimate how much you’ll need, and it’s difficult to say since you are looking 30+ years in the future. Financial counselors determine retirement requirements using many measures. Many advisers advise clients to save enough money during their working lifetimes to replace 70-85 percent of their pre-retirement income. Some even propose 100 percent or more to earn the funds required to pursue a hobby or trip.

But 70-85 percent is quite a general rule, and depending on your preferred lifestyle, your goals may be different. For example, if you save enough now, you could let your investments work for you until retirement without ever contributing to your assets again. Another method is to keep working a fun part-time job to cover your basic expenses while you only withdraw part of your investments, allowing them to grow over the years. So, as you can see, there are many ways to use your money to enjoy your life if you do it according to your goals.

Assess your risk-reward profile

Risk-reward is a broad trade-off that underpins practically everything that can create a profit. When you put money into something, there is always the possibility that you will not get your money back. Losing all your money can happen if a company goes bankrupt, which is classified as company risk. You expect a return to compensate you for future losses in exchange for taking on that risk. In principle, the higher the risk, the more you should retain from the investment.

It would help if you understood that when you invest, you’re always looking for the perfect balance between risk and reward. Still, the amount of risk you’re willing to take will impact your returns significantly. To elaborate, if you’re into risky investments, it might be wise to allocate only 5 percent of your take-home pay to this cause. In comparison, you put 10 percent towards safer investments to create average but stable returns over more extended periods. Generally, financial advisors say it’s best to allocate 10-15 percent of your income to safe investments.

Liquidity risk in terms of risk and reward is precisely why you should ensure you maintain a sufficient balance in your emergency fund to cover unnecessary expenses. Don’t be fooled. When markets drop, they drop quickly. Often, stock drops correlate with a recession and years of high unemployment, which you should prepare for since most people can lose their job in a split second.

What is considered safe?

Calling 10-15 percent a safer investments is rather vague. What is considered safe depends on many variables, and the percentage of your income you invest depends heavily on many variables. Before making any investment, you should constantly evaluate how long you must keep your money invested. First, a longer investing period can make your assets safer. To illustrate, if you have $1 million to invest today but need it in a year for a down payment on a new house, placing it in riskier stocks is not the best option. The greater the volatility or price changes of an investment, the greater its risk. Consequently, if your time horizon is particularly short, you may be forced to sell your shares at a considerable loss. With a longer horizon, investors have more time to recover potential losses and are therefore potentially more tolerant of more considerable risks.

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Your situation also affects the percentage you should invest.

Let’s say you’re 40 years old, with a lot of credit card debt at high-interest rates, and you would like to retire at 60. You will have to start paying down your debt before you begin investing. This will take time, after which you’ll need to create an emergency fund. Let’s say you paid off debt and built your emergency fund by 42. To reach $1 million against an 8 percent return, you must invest $2,147.53 per month to reach your goal. Because you have a shorter time frame to invest, you’re getting less for your buck in terms of compound interest.

On the contrary, let’s say you’re 21 years old and want to retire at 60. You’ve already built an emergency fund and have no debt. You have many years to let compound interest work for you, so you’ll only need to contribute $365.05 per month to reach your goal of $1 million at 60. Because you have a longer time frame for investing, you can let compound interest work for you.

Calculate the approximate amount you’ll need to invest

Specific calculators can tell you exactly how much you’ll need to invest monthly or annually to reach your investing goal. These calculators range from highly complicated with many features to simple ones that calculate whether you make your goals based on the starting amount, monthly contribution, return on investment, and investment span.

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We recommend reading through this article carefully to develop a plan that suits your needs, goals, and lifestyle. In addition, it might be wise to come up with a monthly figure that you would have to invest and make sure it’s realistic. For example, if you want to have $500,000 in 30 years against an 8 percent return, you’d have to invest $354.97 monthly. If your take-home pay is $2,500, your funded percentage should be approximately 14 percent at this time of your life. Of course, you will increase your income over time, and you can either maintain 14 percent or gradually reduce your monthly investment.

Have you done everything? Stay the course!

Keep going! It’s tough to save “far too much” money if you do not deny your needs. Consider yourself, and don’t forget to enjoy life along the way. Once you choose a percentage and can deal with it effectively, your lifestyle shouldn’t change too much, and you will start living on your budget comfortably. For those struggling to reach 20 percent, test your limitations and strive to expand them. Building financial strength requires dedication, consistency, and a willingness to listen to your needs (or your bank account) when it tells you that your current approach is too hard.

However, saving more money is a good idea. Many retirement experts now believe that the old suggestion of saving 15 percent of your income is too low to ensure a good retirement and that saving 25 or 30 percent is a better option.