77% of Americans are stressed over their finances. If you’re fretting about which investment to buy, or what money move to make next, you are not alone. By creating and implementing a plan, you can feel more secure. Whether paying this month’s bills on time or leaving a legacy to future generations, everybody has distinct financial goals. By identifying those specific goals and planning for them, you can make your money work for you, not the other way around.
1. Set your short-term goals
First, set your goals.
Identify your goals in the short-term and long-term. Your short-term goals should be measurable and attainable in the next couple of years. Whether going on vacation or maxing out a 401(k), you should be able to set numbers to it. Your long-term goals can be less specific, but they should be important.
Suppose you’re just starting out in life. You’ve got stable income and $150,000 saved. (You can use this template and substitute your own goals and information.) First, you’ll want to set your goals:
- Short-term: Pay all bills, Keep an emergency fund, set aside down payment for a house
- Long-term: Start a family, pay for children’s expenses, retire at a reasonable age
2. Separate your money and create a short-term strategy
With a big short-term goal of a home purchase, you allocate $90,000 for a down payment. Adding in another $10,000 for emergencies, the short-term bucket is $100,000 total. The remaining $50,000 goes in the long-term bucket.
Because you’ll need the money within a couple of years, you should take very little risk with these assets. A high-yield savings account is a safe way to modestly increase your short-term assets, and it’s generally FDIC insured. While these returns won’t be worth showing off, they’re the safest way to earn money. For example, a savings account earning 0.5% while you’re home-shopping will earn $500 per year on that $100,000 in short-term savings.
3. Pick an investment strategy that will grow
Once you’ve determined everything the short-term bucket, then invest all the remaining funds so your future self will thank you. This is where you target high returns, which means taking risk.
Several difficult-to-predict factors will complicate your long-term strategy; it’s hard to know future income or your children’s tuition bill. Therefore, it’s important to put your mental health first and decide on a risk level you’re comfortable with. The S&P 500 has returned 10% over the last 30 years, but it can also decline by as much as 50% in a year (hi, 2008).
To determine your risk tolerance, ask yourself one simple question: Am I comfortable if the value goes down by 10% next year? If your answer is yes, keep asking yourself that same question with a higher X value until the answer is no.
Since this is long-term money, it will have ups and downs. However, as long as the biggest public companies continue delivering value to their customers and growing, your investments should yield strong returns in the long run.
Because average investors underperform, a buy-and-hold strategy generally works best. It’s also important to only check your investments periodically, as checking their values daily tends to induce emotional decisions.
For the long-term bucket, you can either buy index funds, stocks, or both. Index funds are a much easier to way to diversify, and you can purchase ETFs such as the Vanguard S&P 500 ETF (NYSEMKT: VOO), complemented with with smaller companies through the iShares S&P Small Cap 600 ETF (NYSEMKT: IJR).
For stock pickers, do your homework on the best and worst case scenarios. After diligent research, you should buy 10-25 stocks that you believe have strong potential for strong returns, while maintaining a diversified portfolio.
Regardless of whether you choose stocks or index funds, it is critical to separate your assets according to your goals. By specifically identifying how much you need in the short term, you can make safe, liquid choices with that money. Then, you can invest for higher returns in the long term.