How Much Should I Invest? (Investing For Beginners 3)
Investing is like a long car journey. You want to get to your destination as soon as possible, but driving too fast makes you more likely to crash. Similarly, investing more of your money may earn you a bigger return, but investing money you may need could have bad results. It is wise to only invest money that you don’t think you will need until you reach your goal. You should always keep a reserve of money to tide you over if the worst were to happen.
You may think there you couldn’t afford to lock-up your hard-earned money for a long period of time. However, you could be surprised. Even sacrificing a £3.00 coffee per day adds up to almost £1100 per year. Setting up a small regular payment into an investment account is often a good idea for anyone who doesn’t have a lot of money to spare. Even if the amount you are paying in seems insignificant at first, it will add up over time.
Think of investing as a way of sacrificing a little now for a much larger reward later on. The longer you leave money invested, the more it will grow. This is thanks to the so-called ‘eighth wonder of the world’, compound returns.
Before you set off, decide where you’re heading
If investing is like a journey, you will clearly need to have a ‘destination’. Your chosen destination may range from making a big purchase like a house or car, to having a break in employment or being prepared for retirement.
It is useful to set and work towards a reasonable timeframe in which you want to achieve your objectives. Some people invest for a vague notion such as ‘greater financial freedom’. It is good to have an idea of a timeframe for this goal. The best way to keep your money will change depending on how long you are not going to need it for. My next article, ‘Which Investment Account Should I Use?’, will go into this in more detail.
The diagram above shows some short-, medium- and long-term objectives that many people work towards. Short-term objectives are less than five years away, medium-term can be five, ten, or sometimes more. Long-term objectives are mainly to do with preparing for retirement.
In any car journey, you are clearly going to need fuel to get to your destination. Similarly, you need to have enough money to live on while your investments work towards your goals for you. If you end up having to sell investments to cover your expenditure, this defeats the point of investing. It’s useful to work out if you tend to have any of your income left over every month. You shouldn’t invest more than you are able to regularly afford. If you don’t often have money left at the end of the month, it may be worth having a think about what you could sacrifice to work towards your other goals.
Keeping your journey on track
Developed markets have always recovered from crashes and continued to grow throughout history. However, being forced to sell investments when markets are low means that your losses go from being just a number on a screen, which can recover, to money in the bank, which can’t.
It is impossible to predict with certainty when the next period of market turmoil will be. It is therefore important to ensure that you aren’t forced to rely on your investments at the wrong time. Market turbulence can last a few months, a year, or sometimes two years or more. If you have money invested that you plan to spend soon, a market crash could damage your prospects of meeting this goal.
It is wise to keep a pot of money aside for expected items of expenditure like a holiday, or home maintenance. In the investing world, we call this a ‘capital reserve’. Your capital reserve is like the money you expect to need on your long car journey, whether it’s to refuel your car or to visit somewhere nice along the way. It should grow and shrink as your expected expenditure changes over time.
Bumps in the road
It is also sensible to have an ‘emergency reserve’ for unexpected items of expenditure or sudden loss of income. Imagine your emergency reserve as your spare tyre in the boot of your car, or perhaps your breakdown coverage. It may be unlikely that you will have to use it, but you will surely not regret having it if needed.
Imagine there is a recession and you lose your job. A recession is normally accompanied with a market crash. Needing to sell investments in a crash to make up for your lost income could be particularly damaging for your prospects.
At BpH Wealth, we recommend that the minimum you keep in an emergency reserve is three months of your income. Or, more specifically, the amount you would be willing and able to live on if the worst occurred. It may be appropriate to keep more than this, in some cases anywhere up to twelve months is more appropriate. This will depend on factors like how long you think it would take you to get rehired and how much you have set aside in capital reserves for planned expenditure which could be delayed.
If you are new to investing, and you can’t afford to put that much cash away in one go, it may be wise to set up two regular payments. One into your investment account to work towards your medium-term and long-term goals, and one into your emergency reserve. This should be kept in a separate bank account or savings pot in your account.
The final stretch
You are nearing your destination, and you turn off of the motorway to go down some country roads, or perhaps into a city centre. Clearly, you are going to need to drive slower if you want to make sure you arrive at your destination in one piece! Similarly, as medium-term goals become short-term ones, you are most at risk if the market were to fall.
When coming up to the point where you are going to spend your money, you will need to increase your capital reserve. It is easy to think you could make a little bit more if you held on a little longer. This is risky. It is better to sell and achieve your goal when you want than putting yourself at risk trying to squeeze out a little more.
You may want to use lower risk investments such as high quality, short-dated bond funds in this transition period. However, most of your investments should be in cash if you are going to need the money soon. It may be wise to sell your investments periodically as you come up to the point at which you’ll need them. This means that some of your money could still potentially grow, but overall, you are less exposed if markets were to fall.
Next up
Knowing how much you should invest and how much you should have in cash is only half of the story. Knowing what kind of investment account you should use is the other. I will combine what we have learned my previous article and this one to show which accounts are most suited to meeting short-, medium- and long-term goals. Follow my LinkedIn if you want to see when I post new articles.
Risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, platform or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
This article was produced for educational purposes and aimed at UK residents.
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