How much money should we enjoy now, and how much should we set aside for the future? How much of the latter should be allocated to saving, and how much should be committed to investing?
Saving and investing involve budgeting, discipline and habit. They hold the key to growing a pot of over £1,000,000 over time.
Growing wealth does not usually happen by accident. It takes focus and dedication. Yet, it can be achieved with a strong plan and the right mindset.
Saving vs. Investing
What are the concrete differences between saving and investing, and why do they matter?
Firstly, saving is simply “deferred consumption” – money you have not spent but plan to spend later. Investing, by contrast, is a continuous process intended to achieve an income or profit.
Next, cash is what we typically mean by ‘savings;’ it has a low-volatility. You might say it is ‘low risk’ but it carries several risks including:
- Inflation risk – because inflation erodes the buying power of cash over time.
- Shortfall risk – because the return of cash is lower than equity-based returns over time, and if you plan on ‘saving’ for your future years, you will have to try considerably harder using just cash, given the expected (and achieved, long-term) returns.
The potential returns from interest rates are low (often below inflation), and the timescales are short – e.g. 0 – 5 years. So think of cash as ‘savings’ for an emergency pot and for spending.
Investing, requires careful management of risk and volatility. Investing means using equities, stocks and shares. Returns are intended to beat inflation at minimum, with an investment period of 10 years or more. All the data we have confirms this.
Understanding these differences helps reveal the utility of cash compared to other asset classes geared towards investing (e.g., equities, bonds and property).
For instance, cash often lends itself to building easy-access emergency savings, whilst investing can unlock the growth potential required to build a retirement fund.
For more details about the comparison between saving and investing, we recommend you watch our short Tandem Talks video on this topic.
Pay Yourself First
Many people simply try to save whatever is left after they spend their money. However, Warren Buffet puts a fresh perspective on the matter:
“Do not save what is left after spending; instead, spend what is left after saving.”
This is sometimes called a “pay yourself first” mindset. That is, before you start spending your pay cheque on all your living expenses, set aside the money you need for your future goals.
A common way to implement this approach is to allocate a predetermined amount of your pay cheque – at the moment of receipt – into savings, investments or both.
How much should you “pay yourself first”, though?
It helps to have a philosophy to guide you on this question. At Tandem Financial, we often use rules of thumb like the “50/30/20 Rule” to help clients weigh budgeting decisions.
In short, 50% of your pay cheque goes towards necessities like mortgage, bills and food. 20% goes to savings, and investing. The remaining 30% is at your discretion.
For instance, suppose Michael earns a net income of £4,000 per month. £2,000 (50%) will go towards the “necessities,” £800 (20%) goes towards saving and investing and £1,200 (30%) is for discretionary spending.
However, these percentages are only approximate, and for you, it may differ considerably. If you have no mortgage, you should consider saving/ investing say up to 50% of your income, especially if you want to achieve financial independence at an earlier age.
For more ideas and inspiration about following a principle like the 50/30/20 Rule, see our Budget Planner/ Cash flow spreadsheet from the Tandem Bookshelf.
Allocating between Saving and Investing
No universal rule dictates how much you should save versus investing. Rather, you need to consider the unique variables which may influence your situation, such as:
- Your personal financial goals.
- Your financial position – e.g. income, expenses, assets and liabilities.
- Your attitude to risk and volatility.
- Your time horizon (how long until you need the money you are saving/investing?).
This means that each individual may approach saving and investing differently. For instance, one person might save 20% of their income and invest 10%. Another might only save 5% and invest 15%.
Even over one person’s lifetime, the split between the two might change, as their objectives, circumstances and attitudes change.
A good starting point is to consider your current position. In particular, are your finances vulnerable if you (or a loved one) encounter a serious illness or injury?
Financial planners often recommend building 3-6 months of living costs in easy-access savings (e.g., cash in an instant access savings account) to maximise protection.
This financial “buffer” helps you avoid turning to credit, such as credit cards or costly personal loans, if you suddenly face a large expense, like a broken boiler.
Another good idea is to check your liabilities. Do you have any expensive outstanding debts, like unpaid credit cards?
Prioritising these is more beneficial than focusing on investing since the interest rates on the debts will likely exceed any returns you can realistically achieve. But it is definitely about balance and personal circumstances, and so one should never over pay debt completely to the detriment of investing.
Assuming these priorities have been met, individuals can turn more attention to other key areas – such as saving towards a short-term goal (e.g. a mortgage deposit) or investing towards a longer-term goal, such as building a retirement fund.
Staying Committed to Your Plan
Once you have determined your budget (which you should review at least every 3 months or so), it is time to commit to your saving and investing plan. This involves three key steps:
i. Regular premiums and lump sums – you must put money in
ii. Time – in the market (not timing the market)
iii. Discipline – to keep going through thick and thin.
If you cannot contribute large amounts regularly to a portfolio or savings account, then start small. Even £10 a month gets you into the habit of paying yourself first.
Each three months, revisit your budget and see if you can stretch your contributions a bit further – even if it is just another £5. By the end of the year, you will have gained a lot of momentum.
Please don’t hesitate to contact your Tandem adviser to find out more about the topics covered.
