Thursday, August 01, 2013
To optimize control of the flow of money in one's life, it’s helpful to use the metaphor of cascading “money buckets.” Just as a series of linked buckets store and direct water, one into the next, money buckets hold and control the movement of money in your life.
You’ll need four basic money buckets, each flowing into the next, in the following order.
1. Checking Account
The top-most bucket is your household checking account into which paychecks and other income is deposited and from which bills and other expenses are paid.
This bucket should contain an amount sufficient to pay at least one but no more than three months of essential expenses. For example, if your essential monthly expenses total $2500, your checking account balance should be maintained between $2500 and $7500.
Once this bucket is full, extra money should be transferred into the next bucket:
2. Emergency Savings
It’s prudent to have an emergency cash fund equal to 3-6 months of essential monthly expenses. For an extra benefit, this money can be stored in a savings account linked to your household checking account, providing overdraft protection to the checks you write. For example, if your essential monthly expenses total $2500, this fund should contain between $7500 and $15,000.
This is your “attitude money.” These emergency funds allow you to have a “positive attitude,” knowing that, should an emergency arise, you’ll be well able to handle it.
Likewise, once this bucket is full, extra money should be transferred into the next bucket:
3. Retirement Savings
Always take full advantage of employer contributions toward your retirement savings! For example, if your employer will add an extra 3% if you commit 6% of each paycheck toward 401K or other retirement accounts, be sure to do so. This is free money!
It’s generally a good idea to maximize tax-advantaged retirement savings opportunities (adding a Roth or Traditional IRA, etc.) – but you’ll also want money to flow into general investment accounts, since retirement investments are hard to access until you hit retirement age. Set a sensible maximum amount for yearly contribution toward retirement funds, based on your income, in consultation with a tax accountant or other trusted advisor who understands your situation and applicable tax laws.
Again, once this bucket is full, extra money should flow into the next bucket:
Investment accounts should be further split, in roughly equal amounts, into passive and active investments.
Passive investments include lower risk, highly-diversified vehicles like index funds/ETFs and the like. The strategy is to buy and hold, no matter what, and take advantage of the market’s 10% average annual growth to virtually guarantee you’ll make huge profits in the long run. You’re not trying to beat the market, here; you’re simply joining it. Most or all retirement savings should be held in passive investments vehicles.
Active investments include particular hot stocks, precious metals, REITs (real estate funds), and even commodities and futures contracts. The strategy here is trying to beat the market. This is gambling, essentially. Sometimes you’ll win, sometimes you’ll lose. With study, and some good luck, your big wins will more than make up for your losses, and you’ll have fun trading in and out of these positions, swinging for the fences.
It’s a good idea to put more into passive investments and less into active investments, the more you dislike risk. But if you have the interest and can afford the time to study various investment opportunities, the rewards of active investing can be more than worth the risks, especially if you’re young and have plenty of time to earn back lost money.
It’s mathematically impossible to beat the market over a long enough period of time. Gamble intelligently. Put at least half your investment money in less risky, well-diversified passive investments. Don’t become too euphoric when markets are going up, and don’t worry much when markets go down. Just keep buying and holding your passive investments, following a methodical investment plan. Invest rationally, not emotionally.
As your investments rise and fall in value, it’s important to look at your entire investment portfolio periodically and rebalance it (perhaps 1-4 times a year).
Once your investments have grown, use them to fund goals that bring joy to your life: owning a home, travel and vacations, buying cool toys, giving to others, making the world a better place, etc.
Copyright © 2006-present Christopher R. Borland. All rights reserved.