Thursday, April 13, 2017

How Much Of My Savings Should I Invest?

There are many ways to decide how much of your salary goes to investments. At the end, it all comes down to what your financial goals are.
 
Many Singaporeans want to know how much of their salary should go to investments. There are many approaches to deciding this. In the end, what it comes down to are your individual financial goals. If you want to retire with five houses and a yacht, you will have to invest much more aggressively than someone willing to retire in a rental flat. Here are some ways to work it out:
 
Method 1: Work Backwards From the Amount You Want
This is the most common method, and many Financial Advisors or wealth managers can do this for you. To decide how much you need to invest, you first work out how much you want to save. You then work backward from this amount. For example, let’s say you want an income of S$2,000 a month when you retire. You want it to stretch from the age of 65 to 80. You would need about $24,000 a year, or about $360,000. If that seems too easy to be true, it is: the real amount you need will be a lot higher, because of the effect of inflation. Let’s assume you are 25 years old right now, and that the rate of inflation will be more or less three per cent throughout the next 40 years (most developed countries have an inflation rate of about two to three per cent). Now over 40 years, S$360,000 will decrease in purchasing power. In fact, by the time you are 65, it will only have as much purchasing power as around S$110,360 today*. That’s not what you want; you want to have the equivalent purchasing power of S$2,000 a month today, at the time you’re retired. So you need to aim a lot higher. You’d need to have, more or less, S$1.174 million by today’s standards**, in order to have the same purchasing power as S$360,000 in 40 years. Now we can start working out how much you need to invest: Let’s say you build a balanced, diversified portfolio that earns returns of five per cent per annum***. If you can set aside $10,000 a year to invest (about S$830 a month), you could potentially reach this goal in about 39.5 years. So that being said, the general idea is to work out the amount you need post-retirement, factoring in inflation. Once you have the required retirement amount, and you know what returns your investment portfolio provides, you can decide how much you need to set aside to invest.
*retirement amount / (1 + inflation rate) ^ number of years
**retirement amount x (1 + inflation rate) ^ number of years
*** Your CPF Special Account can pay out this rate of return, and you can make voluntary contributions to enhance it
 
 
Method 2: Invest Everything After the Emergency Fund
This method, while not precise, is simple to understand and follow. Using this approach, you first save 20% of your income per month to build up an emergency fund. This fund should consist of six months of your income. The emergency fund is the savings you will use to deal with emergencies. As your income rises, or you spend from the fund, you will have to top it back up to the six-month limit. Whenever the fund is at six months of your income, the 20% you’d normally save is instead used to invest. This can go into a mutual fund, blue chip stocks, index funds, etc. You will still need to pick the assets intelligently of course, and secure a good rate of return (speak to a financial professional). However, you can be assured that emergencies will not disrupt your investment – if something goes wrong, such as retrenchment, you can tap your emergency fund instead of taking money from your retirement portfolio.
 
Method 3: Fixed Ratios
This is a traditional approach, in which you fix ratios to save and invest. Typically, this is 20% of your pay for savings, and 15% for investing. This requires very little thought or planning. If you automate the process, such as by GIRO, you won’t feel the pinch of having to set aside the amounts. However, this simplicity comes with limitations. For example, you may not notice that you are saving too little for retirement, as there is no actual planned amount to reach. You may also end up saving much more than is necessary for an emergency fund. Remember that cash savings, such as leaving money in your bank account, ultimately leads to stagnation. The value of the money decreases as it’s not growing, and it won’t keep up with inflation. If you save an unnecessarily large amount, you may ultimately be losing out.
 
 
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