In our previous article in this series we defined what true financial planning meant. Many people simply invest their money to get the best returns possible. But within a financial plan it is essential that your investments are designed to support your lifestyle.
The first thing to consider is an emergency fund. The textbooks will suggest holding capital to the equivalent of between three and six months’ income which can be drawn as at short notice.
However, a more reasonable amount should be what feels comfortable to the individual, giving some consideration to the cost of an emergency that is not insured.
For those in work, we would suggest a minimum of six months’ salary, to ensure you can continue to fund your lifestyle should you lose your job. This will give you a comfortable period to find a new job.
After ring-fencing your emergency fund, consider what expenditure above normal income you may require in the next five years.
This money should be invested with relatively low risk, but possibly with a longer notice period. These funds can be used for funding expenses that exceed normal income, such as holidays.
Longer term funds can be invested to achieve a higher return, depending upon your personal risk tolerances, to provide wealth for retirement or funding bucket list expenditure.
There may be other specific objectives, such as children’s weddings, house deposits or university. These need more detailed planning to take into consideration:
- The cost today
- The future value of those costs
- When the money is likely to be required
- Inflation (but the Retail Price Index may not be a good inflation assumption). For example, education fees often rise at a higher rate than inflation.
Once you know the target value, and the assumed rate of returns on your investments, you can then calculate how much you need to save.
If you have a specific budget, you can calculate the returns required – and therefore the level of risk you need to take with your investments.
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