Asset Allocation: Net Positive Income – a Good Problem to Have
It’s great to be ‘in the black’ with your net income, simply meaning that more money is coming in than being spent. This is different that being 100% debt free. All it means is that you are not accruing more debt due to a negative cash flow.
When you’re relatively young one of the most daunting questions can be ‘what do I do with all this cash?’. It’s a nice problem to have, but without a strong financial background, the default solution often tends to be to stick it away in a savings account or certificate of deposit. Next to spending it or placing it under your mattress, this is about the worst thing you can do with your extra income, but more on that later. In general, one of the toughest decisions to make in personal finance is to figure out where the heck to put your money because it involves answering a lot of tough questions. Let’s get the easy parts out of the way first.
A Guide to Asset Allocation
Step 1: Starting an Emergency Fund
Many experts recommend that you save 2 to 3 months worth of your current salary to put into highly liquid (quickly and easily usable) assets. For your emergency savings, I would recommend opening a high interest money market account. You can do this through a discount broker or through your local bank. You may want to compare rates before selecting one. A money market is essentially a high interest savings account that gives you a high interest rate because you are required to deposit and maintain a higher balance than a regular savings account.
Step 2: Look at your Debt Situation
Once you have an emergency fund established, you’ll need to ask yourself the following questions to figure out where to next allocate your extra cash flow:
- Do I have any debt?
- If so, at what interest rates?
If the answer to the first question is yes, read this post on debt payoff. As a general rule, if you have high interest bad debt you want to pay it off before investing in anything else. The one exception to this rule would be if you have an employer match on contributions to your 401K, with the match rate being higher than your bad debt rate. If this is the case, you may be better off getting your match and then fighting your debt, but not everyone agrees on this point.
There is more of a consensus that if you have good debt at a low interest rate, then you’re probably better off paying your minimum monthly payments and investing your leftover money.
Step 3: Figure out what type of Investment Makes the Most Sense
- Why Putting your Money into Savings Accounts or CD’s for Long-Term Investing is a Bad Idea. According to the Bureau of Labor Statistics, the average inflation rate over the past 20 years has been 3.24% and in the past year it has been at 4%. With rapidly increasing fuel and food prices, you have to wonder if inflation rates are currently on the rise. At the same time, certificates of deposit are paying around 4.5 to 5% interest. Most savings accounts pay less than 1%. Subtract the minimum 15% you’d be paying in taxes on earnings and it’s easy to see why you would have to consider yourself lucky to see the value of your money stay flat when left in certificates of deposit. In a low interest savings account, you’d actually be losing value in your money over time.
- So Where do I put My Retirement Money? Many experts disagree on exact asset allocation percentages once you near retirement, but if you’re under the age of 40, it’s hard to make a strong argument against not having 100% of your investments in stocks via individual stocks or mutual funds.
- Making a Case for Stocks: The average annualized rate of return for U.S. stocks was 13.4% from 1926 to 2000. The worst average annual rate of return for U.S. stocks in any 65 consecutive year period has been 8.5%. If you would like a conservative estimate, go with 8.5% in your calculations. How does this stack up against other investments? Large U.S. stocks have dominated all other investment types over long periods of time in terms of real returns (factoring in inflation). Every $1 invested in stocks since 1926 is now worth $271.72. $1 invested in long-term U.S. treasury bonds over the same time would be worth $5.77. Corporate bonds? $8.89. Treasury bills? $1.72.
Step 4: Figuring out how Much to Save for Retirement
In order to figure out how much you need to save for retirement and for early retirement, you need to work backwards and make a lot of educated guesses on the following questions:
- What age will I live to?
- What will my annual expenses be in retirement?
- What percentage increase in salary can I expect to get on average per year?
- How much in retirement savings will I need to meet my expenses until the age that I die? For this one, consider the fact that in order to receive full Social Security benefits you can’t begin getting payouts until age 67 and you can’t pull distributions from your retirement accounts (IRA’s or 401K’s) until age 59 and 1/2 without penalties.
- What age would I like to retire at?
- How much money will I need to get from my early retirement age to the point that I can begin withdrawing distributions from my retirement accounts without penalty at age 59 and 1/2?
Each of these questions are a post’s worth of material within themselves and will take a little bit of time to figure out. Since they do involve a little bit of guesswork you’re probably going to want to be as conservative as possible with your estimations. Here are some retirement calculators to help you figure it out:
- CNN Money Retirement Calculator
- Bloomberg Retirement Calculator
- Choosetosave.org ‘Ballpark’ Estimate Calculator
Step 5: What Investment Vehicle do I Allocate my Money into?
Once you know how much you need to save and in what amount of time for both early and official retirement (withdrawing distributions without penalty), you can figure out how much to allocate to each. My first recommendation would be to get the maximum match possible from your employer within your 401K. Once you get this, your asset allocation breakdown should be to distribute between taxable personal accounts and retirement accounts (IRA’s and 401K’s) at the level that will allow you to reach both your early and official retirement goals.
What is Asset Allocation? Here’s a Summary
Asset allocation is rarely an exact science and it involves a lot of subjective guesswork on your part. It also depends on how comfortable you are with certain strategies. The steps provided in this post are simply guidelines to give you a better idea of where you should be putting your money. Ultimately, your final asset allocation will be dependent on your lifelong values and goals.
Asset Allocation Questions
Where are you putting your money and why?