About 75% of millionaires in the U.S. achieved their milestone through regular and consistent investing, according to a national survey by Ramsey Solutions. The study also found that 79% of millionaires did not receive any inheritance.
In other words, you don’t have inherit a windfall to become a millionaire. Through a systematic approach to investing, you can slowly, steadily and surely build your way to wealth.
[Sign up for stock news with our Invested newsletter.]
But what would that look like every month? In other words, how much should you be investing every month to consistently build wealth and take advantage of compounding, which Albert Einstein (supposedly, at least) called the eighth wonder of the world?
— How to use the 50/30/20 rule.
— Put your finances in order.
— Saving vs. investing.
— How much should you invest per month?
— When you need to save more than 20%.
It Starts With Budgeting: How to Use the 50/30/20 Rule
The 50/30/20 rule is a budgeting system that was popularized by Elizabeth Warren, a senator from Massachusetts. It is a popular system that many financial experts have recommended.
This system requires that you spend 50% of your income on your needs (mortgage/rent, groceries, clothing, transport, etc.), 30% on your wants (internet subscription, hobbies, eating out, etc.) and save or invest the remaining 20%.
However, note that there are some, especially those in the Financial Independence, Retire Early (FIRE) movement, who save far more than 20% of their income (up to 70% in some cases).
If your financial situation permits, you can save or invest more than 20% of your income. Nevertheless, if you have not used a budget before, the 50/30/20 rule is a good place to start.
Before You Start Investing: Put Your Finances in Order
Before you start investing in the financial markets, you should do two preliminary things with the 20% of your income you are saving: Create an emergency fund and start paying off bad debt.
Create an Emergency Fund
An emergency fund is money you keep aside to take care of unexpected expenses. It may be a trip you didn’t plan, some out-of-pocket medical expenses your insurance doesn’t cover, or the loss of your phone, among others.
The standard is for you to have three to six months’ worth of your monthly needs and wants (also called living expenses) in such a fund.
For example, if your income is $5,000 every month, $2,500 will go to your needs, $1,500 to your wants, and $1,000 for saving and investing. In this case, your monthly living expenses add up to $4,000, which means you will need an emergency fund of between $12,000 and $24,000.
A useful strategy is to start with an emergency fund worth three months’ living expenses and expand it to six months’ living expenses later.
Also, if you have a stable job in a stable industry and a small number of dependents, you may not need to increase your emergency fund.
Why Start an Emergency Fund Before Investing?
If you invest without an emergency fund, you may need to liquidate your investment assets when emergencies arise. Since the stock market is volatile in the short term, you might have to sell off some of your investments at a discount (at a lower price than you bought them), resulting in a capital loss.
Pay Off Bad Debt
In personal finance, a bad debt is an expensive debt you incur to purchase depreciating assets or buy things that won’t increase your future income. On the other hand, a good debt is an inexpensive debt you incur that will increase your net worth and future income.
Student loans, mortgages and business credit are examples of good debts, while payday loans, personal loans and credit card debt are examples of bad debts.
Because bad debts are generally expensive, it is better to pay them off before investing. Why so? The interest rates on some of these debts exceed the rate of returns that you can even get in the stock market. Thus, paying them off can be a better use of funds than investing in the stock market.
You can use the debt snowball method — where you start with the smaller bad debts and then use the momentum to attack the bigger ones — to clear your bad debts.
One final point: Have an emergency fund before you start paying off debt aggressively. If an emergency arises when you don’t have an emergency fund, you will be forced to take on more debt, which defeats the purpose of the debt repayment process.
Start Your Monthly Investment Plan
Once you have put your financial house in order, you can start committing 20% of your monthly income to saving and investing.
Saving vs. Investing
What’s the difference between the two? Simply put, saving is for short-term goals (purchasing a new TV, going on vacation) and medium-term goals (making a down payment on a property, getting an advanced degree) while investing is for long-term goals (retirement, starting a business, leaving an inheritance, financial independence).
This distinction is necessary because the vehicles to achieve these goals are different. For short-term and medium-term goals, capital preservation is the priority.
Thus, you want to put your money where you are confident that its value cannot fall. Possible vehicles include savings accounts, high-yield savings accounts, money market mutual funds and fixed deposit accounts, among others.
In contrast, for long-term goals, capital growth is the priority. Therefore, you want to put your money where you earn high risk-adjusted returns and benefit from the effect of compound interest. Assets of interest can include bonds, stocks, gold, real estate investment trusts (REITs), Bitcoin, exchange-traded funds (ETFs) and equity mutual funds, among others.
With these assets, your investment value will fluctuate in the short term, and at any time, it can be less than the amount you invested. However, over the long term, you can be confident that your money will have grown significantly.
How Much Should You Invest Per Month?
There is no straightforward answer to this question. A simplistic answer is to go 50/50, such that you save 10% of your income and invest 10%.
However, it is not always that simple. There are times when you have only a small number of short-term and medium-term goals and saving 5% of your income (and investing 15%) is sufficient. At other times, there may be significant short-term and medium-term goals, such that you may need to save more than 10% of your income, which will mean investing less than 10% of your income.
A better approach is to highlight your goals — short-term, medium-term and long-term — decide how much you need to achieve each goal and then project how much you need to be saving or investing every month to achieve those goals.
Examples of How Much to Invest Per Month
Short-Term Goals
Suppose your short-term goals are to go on vacation in a year and to purchase a new TV in three months. After some research, you discover that the vacation will cost $10,000 and the new TV will cost $2,000.
Let’s say you are saving money in a high-yield savings account with a 4% annual percentage yield that compounds every month. To have a balance of $10,000 after a year, you will need to save $812.89 every month. Also, to have a balance of $2,000 after three months, you will need to save $666.33 every month. Adding those up, you’ll need to save $1,479.22 every month for your short-term goals. (You can confirm these figures using the future value of an annuity formula).
Medium-Term Goals
Suppose your medium-term goals are to save for the down payment of a property in three years and to write a certificate exam in two years. The former will cost $60,000 and the latter $20,000.
With the same assumptions as before regarding returns and compounding, you will need to save $1,574.80 per month for the down payment and $802.05 per month for the certificate exam. Adding up, you need to save $2,376.85 for your medium-term goals.
Long-Term Goals
For long-term goals, let’s say you need $500 every month to contribute to your 401(k) and you also want to open an IRA and contribute up to the limit ($583 per month).
Suppose also that you want to start a business in 10 years with capital of $1 million. If your investment portfolio produces an average annual return of 10% (which is the average annual return of the S&P 500 since 1957), compounded quarterly, you will need to invest $4,904.76 every month to achieve this goal. (You can use an investment calculator to confirm these figures).
Adding up, you will need to invest $5,987.76 every month to achieve your long-term goals.
Percentage of Income Used
If we assume that your monthly income is $50,000, then you will need to invest 11.98% of your monthly income to achieve your long-term goals. Also, you will need to save 7.71% of your monthly income to achieve your short- and medium-term goals. Since the goal is to save and invest 20% of your income, you can allocate the remaining 0.31% (20%-11.98%-7.71%) of your income to either saving or investing.
As your goals change over time, this allocation formula will also change with it. This approach, though more complex, has the benefit of accuracy. It ensures you are not saving more than you need (thus forgoing the higher returns investing will provide) or less than you need (making it hard to achieve some of your short-term and medium-term goals).
When You Need to Save More Than 20%
Another important consideration: The money you need to save or invest every month may exceed 20% of your income. In this case, you can decide to cut down on some of your expenses to fit in all your goals (as we said above, some people save and invest far more than 20% of their income) or you can create a scale of preference for your goals and suspend those that are far behind.
To illustrate, suppose your monthly income is $30,000 instead of $50,000. To fit in all your goals, you will need to save and invest 32.81% of your monthly income. Alternatively, you can create a scale of preference like this one:
Retirement > down payment > new TV > certificate course > vacation > business
Since you want to stick to 20% of your monthly income, the maximum amount available is $6,000. Let’s find out how many goals you can achieve with that amount by ranking goals in a scale of preference:
| Goal With $6,000 | Amount Required | Remaining Amount* |
| Retirement | $1,083 | $4,917 |
| Down payment | $1,574.80 | $3,342.20 |
| New TV | $666.33 | $2,675.87 |
| Certificate course | $802.05 | $1,873.82 |
| Vacation | $812.89 | $1,060.93 |
| Business | $5,987.76 | -$4,926.83 |
*After subtracting previous allocation of funds.
As this table shows, you can conveniently achieve five of your goals. However, you can only achieve 17.72% of the last goal. You may have to wait until you have achieved some of the other goals or increased your income to fully contribute toward the last goal.
Ensure you consider your overall financial situation before choosing any of the two options above: saving or investing more than 20%, or suspending (or partially achieving) some goals.
Takeaway
The example I have used is for illustrative purposes. You can take it as a model you can apply to your financial situation to help you accurately determine how much you need to save and invest every month to achieve your goals. If the process seems daunting, a CFP professional can help you identify, clarify and quantify your financial goals as part of the financial planning process.
More from U.S. News
5 Best Stocks for Beginners With Little Money to Invest
The 5 Best 5-Star Stocks to Invest In
How to Invest in Stocks for Beginners
How Much Should I Be Investing Per Month? originally appeared on usnews.com
