Sunday, June 24, 2007

Building an Emergency Fund

How much should I save? As a rule of thumb, a saving ratio of 20% is considered healthy. Saving ratio is defined as total annual saving divide by total annual income.

As you start saving, your first priority is to build up your emergency fund. Establishing an emergency saving account is vital in both good and bad times. It is an absolute necessity for financial security because it gives you funds to fall back on if you or your spouse lose your job, incur large medical bills, unable to work for certain reasons, and so on. Without an emergency fund, you may be forced into incurring credit card debts that could take you many years to pay off. You don't want to be living on the edge, do you?

To build up your emergency fund, you have to put away the money consistently on a regular basis. As it grows, be sure not to dig into it for non-emergencies purpose. Remember, this fund can only be tapped for true emergencies.

How much do you need in this emergency fund? The minimum amount to have should be at least 3 to 6 months of your basic living expense. It has to be sufficient to tie you over during the period when your income stream is suddenly cut off. So examine carefully your income and needs to decide how much you actually should save. The level has to be comfortable to you.

Where should you be keeping your emergency fund? Emergency fund must be easily and quickly available and accessible when needed. It is best kept in liquid assets. Liquid assets refer to assets that can be converted into cash quickly. Example of such assets include saving account, time deposit, money market funds, and short term bonds. Do not put your emergency fund in property and stocks/shares. Property is not a liquid asset because it takes months to sell it. Stocks/shares are somewhat more liquid than real estate, however you can lose money if you are forced to sell it at the time when the market for your stock/share is less favorable.

Sunday, June 17, 2007

The Power of Compounding

I cannot stress much more the importance of saving if you want to create wealth for yourself. Save and Invest is one good wealth creation strategy that you can easily adopt. The reason you save is so that you can let the money work harder for you. As a start, you work hard for money. But up to a stage when you have accumulated some saving, you have to let the money work for you.

Allow me to show you how saving can work wonders for you. Let me introduce to you the concept called the "Power of Compounding Interest". This comes about because over a long period of time, you will actually experience your money feeding on itself, earning you additional dollar that will accumulate into sizable amount.

Through investing, you can actually double your money over a period of time. How long that is will depend on your rate of return.

If your rate of return is 2%, then it takes 36 years to double your money. Whereas if your rate of return is 7%, it doubles every 10 years.

To illustrate, let's say you have an initial investment of $100k.
If this is invested at a return rate of 2%, in 36 years, your money would have reached $204k.
If this is invested at a return rate of 7%, it will double every 10 years and in 36 years time, your money would have reached $1.1 million.
Which one do you prefer?

So the lesson learnt today is: Do not just leave your money in the bank. You will be missing a lot if you do. Let your money work harder for you.

For those interested to know When? you will double your money with a given rate of return, use this formula. Take 72 and divide it by rate of return (without the %). For example, if I divide 72 by 2, I get 36. This means when you invest your money at a return rate of 2%, it takes 36 years to double your money. Similarly, if your rate of return is 5%, then it takes (72/5) 14.4 years to double your money.

In addition, if you want to prove that it really takes 36 years to double your money for a given rate of 2%, use the future value (FV) formula in Microsoft Excel.

I hope you have learnt something today.

Sunday, June 3, 2007

Why is it Important to Start Saving Early?

A fews days ago , I mentioned that it is important to start saving as early as possible. I would now like to illustrate this in terms of the table given below.

Assume that a person saves $500 per month and assume that his desired age of financial independence is 55. How much funds do you think this person would have accumulated when he reaches 55.

See this:

Starting ------------------------ return per year ----------------------
Age 2% 5% 7% 10% 15%

30 $196,025 $300,681 $406,059 $649,091 $1,468,272
35 $148,700 $208,316 $263,191 $378,015 $ 706,861
40 $105,836 $135,945 $161,328 $209,698 $ 328,305
45 $ 67,012 $ 79,241 $ 88,702 $105,187 $ 140,096
50 $ 31,849 $ 34,811 $ 36,920 $ 40,294 $ 46,522
55 $ 0 $ 0 $ 0 $ 0 $ 0

What does the above table tell us?
  1. There is cost for waiting. A person aged 30 who save $500 and invest at a rate of 7% will reap $406,059 when he reaches 55 whereas a person aged 40 will reap only $161,328. That is 3 times less than the person who starts early.
  2. The longer you delay, the more pain you give yourself. In order for the person aged 40 to achieve the same amount of funds, as the person aged 30, when he reaches age 55, he will have to save much more every month. How much? $1,274 every month (assuming a return of 7%).
  3. How much funds you are able to accumulate shall depend on WHEN you start and the investment returns you get. If you just leave your saving money earning 2% and do not make your money work harder for you, you are not going to get far in reaching your retirement funds either.
  4. It is possible for a person to achieve financial independence just by saving and investing over a sufficient period of time.
For those who are already late in adopting this strategy, do not worry. It is still not too late to start saving now. However in order to achieve your financial independence, you will need to look at other wealth creation strategies as well.