Consider these 3 elements: emergencies, protection, and growth potential
On paper, financial planning is pretty straightforward. But in reality, it gets complicated. Not because of math or complexity but because our emotions get involved. When inflation and interest rates are rising and the markets get rocky, it's easy to let doubt about your investment plan creep in. The good news is that there are ways to work around some of the roadblocks to investing that your brain may be putting in your way. Consider thinking about your financial picture in terms of 3 broad categories: emergencies, protection, and growth potential. These 3 building blocks work together to help make sure you have money for unexpected expenses, insurance to protect your income and home, and growth potential to reach your long-term goals. Compartmentalizing your money like this can help you stick to your long-term investment plan. The emergency fund and protection buckets would ideally cover any unexpected needs that crop up in the short term so that your growth bucket can stay invested
A healthy investment plan contains 3 components: liquidity for emergencies, protection for what you have, and growth potential for the future.
1. Emergency fund-It makes sense for everyone to have some money set aside for the unexpected. While 3 to 6 months' worth of essential expenses is a good starting point, it's important to decide how big your emergency fund should be so that you can sleep at night. Saving 3 to 6 months' worth of essential expenses is a big goal to aim for so if that seems out of reach, $1,000 or enough to cover 1 month of essential expenses is a manageable milestone to aim for while working to save more.
2. Protection- is a critical piece of a financial plan. It includes foundational pieces like life insurance, protecting your income in case of a disability, and basic estate planning. It also includes protecting part of your money from stock market risk. For instance, if you have goals that are less than 5 years away, your investment strategy should reflect that, with less exposure to stocks than you might have for goals that are 20 years away. You may not want any stock market investments for a goal that close. As your life and financial situation scale up in complexity, often as you get older and hopefully become more financially comfortable, the layers of protection you may want could extend to long-term care insurance and tax-efficient inheritance strategies.
3. Growth-Once you've accounted for your emergency fund and protected certain aspects of your life, the growth portion of your plan is where you would put your diversified investment strategy. This component is generally the largest piece of your plan.
Growth potential can help your money keep up with inflation and (hopefully) help you accumulate wealth while staying invested through up and down markets. The key is to strike a comfortable balance between the level of stock market risk you can live with that also lines up with your time horizon, financial situation, and risk tolerance, and that provides the growth potential to meet your goals.
Knowing that you've filled up your emergency and protection buckets can help you stay more disciplined with your growth strategy.
Breaking down your financial life by category and assigning a broad goal to your assets can help you see how the pieces work together. Each bucket has an important role to play and that can help give you peace of mind when the stock market gets choppy. Knowing that you've planned for contingencies and have a cash buffer can help you stay invested through market ups and downs. It also provides ready cash for unexpected expenses so the rest of your plan can stay on track.
Once you have a solid grasp of how your money fits into these broad categories you can work to build each one up to fit your needs. For instance, you may feel a little nervous about investing in the stock market so it could make sense to have a more robust emergency fund so you feel more confident that you can ride out a market downturn and have cash available when you need it. In a similar way, life and disability insurance can help protect your family against a loss of income.