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7 Rules of Thumb for Saving

7 Rules of Thumb for Saving

When it comes to financial freedom, one of the most important rules of thumb is to save money. Saving can help you plan for the future. But how do you know if you are saving enough? Here are 7 savings rules of thumb that can help you plan for your financial future:

1. Cash May Not Be King

While you want to use cash products in your portfolio for elements of liquidity and safety, it is important to realize that your returns on cash are likely to be lower than returns from other types of products. Some of your saving efforts, especially when it comes to retirement, should probably include stocks (funds can be a less risky choice than individual equities) and bonds, along with other investments if you have the risk tolerance for it.

2. Compound Interest Can Be Your Friend

We usually think of interest as the enemy. However, interest itself is not evil. Indeed, that same compound interest that is the scourge of those with high credit card balances can be quite helpful to the savvy saver. What matters is what end of the compound interest you are on. Compound interest is your friend if you are receiving a yield. When you set money aside in an interest bearing account, compound interest is working for you. The money you earn in interest is added to your balance, and soon you are earning interest on your interest yields. Make an effort to understand how this works, and then put your money to work for you.

3. The Earlier You Start, The Better

You’ve probably seen those figures that show you could bank hundreds of thousands of dollars more over your lifetime if you start saving for retirement at the age of 25, instead of the age of 35. The longer compound interest works for you, the more money you will have in the end. If you aren’t already saving, start today. Don’t wait. Every day you wait is one more day that you lose out on the effects of compound interest.

4. Rule of 72

This is one of the most basic rules related to how money goes. It provides a rough estimate of how long it will take your money to double. You divide 72 by your interest rate. If your rate is 3%, it will take 24 years (72/3) for your money to double. So, if you put in $10,000 and just let it sit there, in 24 years you will have around $20,000, and 24 years after that, you will have $40,000. If you end up with higher yields, your money will double faster, and your investments will grow faster, too, if you continue to add to your savings.

5. Set Aside 10% of Your Income

Conventional wisdom says that you should set aside 10% of your income for savings. Assuming a conservative return of 6% (assuming you include stock funds in your portfolio) if you set aside 10% of your income from age 18 to age 67, you should be able to live on your money indefinitely. You can use a compound interest calculator to help you work out how much you could save up if you put away 10% of your monthly income.

6. Estimate Inflation at 3% to 4%

Prices always go up. This means that your buying power goes down. Inflation erodes your real returns, and this can cause problems later on when you try to make your money last. When saving for the future, you need to consider inflation. Most rules of thumb suggest that you estimate inflation at 3% or 4%. If you estimate it at 4% you are more likely to be pleasantly surprised. Simplistically, if your savings yields 6% annual returns, but inflation is 4% a year, your real returns are closer to 2%. If the calculator you use doesn’t adjust for inflation, subtract it from your expected yields on your own. This means that if you want 6% real returns, your savings investments will need to yield between 9% and 10% annually. This is doable, but not if you are using cash. (If you are using cash as your only savings, you could end up with negative real returns.)

7. 20x Your Income to Live Comfortably in Retirement

One of the retirement savings rules of thumb that is rather common is that you will need 20x your annual income amassed in order to live indefinitely on your yields. This rule assumes that you continue to earn 9% a year, live off 5% and lose 4% to inflation. However, this rule applies to amassing a huge amount of money and then living off it with no additional income. Some experts suggest that you look for ways to cultivate different income streams so that your monthly expense needs are met in retirement, rather than relying a large lump sum.

Automate Your Savings

Instead of waiting to consciously put money into savings, many financial types suggest that you automate your savings. This takes the “pay yourself first” concept to the next level. You have money from your paycheck automatically deposited into a retirement account and/or a savings account – before it goes into your checking account. Or you set up an automatic transfer from your checking account so that 10% (or more) of your income is automatically put into your savings account and/or your retirement account. This way, it is done without you having to do it, and you learn to budget what you have after your saving is done, rather than simply putting in what is left after you’ve spent most of it.

Adjusting for Circumstance

Of course, it is important to remember that every situation is individual, and that you will need to adjust for your personal circumstances. Your savings needs may be higher than others’, or they may be lower. Rules of thumb should never be treated as the final word in money. However, they can provide useful guidance as you map out a savings plan that will lead to financial freedom.

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David DuVal
David DuVal   |     |   Comment #1
In today's environment, you really need to be a risk taker to even yield 4%, and there have been bear markets that have lasted 20 or more years. There is reason to believe we are in for a length bear market now. Also, in the current environment, inflation is not 3-4%, and many economist worry about either deflation, or really low inflation for years.   |     |   Comment #2
It is going to be interesting to see how the markets and interest rates play out in the next few years.  Things have got to get better, I hope.  Although I am saving diligently it seems paltry right now.  Ugh..
adityanm   |     |   Comment #3
Your 20x saving is a mirage. How many persons earning 50k can hoard a million?

What about social security which is main source for retirees?
Anonymous   |     |   Comment #4
Generally these were nice thoughts.  The idea however that you need 20 times your income to live comfortably in retirement is not accurate though.  Nor is the idea you need some percentage of your income.  The amount you need to live comfortably in retirement is based on your spending, not your income.  If I spend 30,000 on living at retirement (assumint the house is paid for)  it doesn't matter if my income is 50,000, 100,000 or 150,000 and to base a multiple of any of those three numbers is not accurate either.  Conversely, if you spend 50,000 but only have an income of 30,000, 20 times 30,000 will be nowhere near enough.  The ides that you may need 20 or 25 times your current annual "spend" may be an appropriate number, assuming your spend remains constant in retirement (which it won't). 

One should not just live within one's means, but make consious decisions about spending.  The freedom that comes from spending less really does prrove that less can be more.   Conscious and voluntary simplicity is a wonderful thing.....go for a walk and think about it.  It doesn't cost a thing. 
51hh   |     |   Comment #5
No matter how one figures, it all comes down to some impractical rule of thumb on "how much one needs to retire."  If one calculates the 4% withdrawal rate, it shows the same number.  Assumes one earns $100K, 80% is $80K.  The 4% rate shows the sam $2M as the 20 times the salary.

Only one himself/herself knows how much it takes for a comfortable and realistic retirement and each case is different.  Such calacualtion yields unrealistic goals that one may never achieve in one's lifetime, therefore, work till one dies.

Retirement is a mentality in the state of mind.  In most countries, there is no 401K but people retire early and live happily ever after.  The prudent approach is to save as much as one can while, very important, still enjoy one's current living.  When one feels physically/mentally ready, one shoud just reitire and continue to enjoy life to the utmost.  To some, that age may be 60, to others, it may be 75.  Why put a stress level on retirement as if there are not enough goals in life??!! 
dakar   |     |   Comment #6
On using an inflation figure of 3-4% for retirement calculations :  Dream on!  To see what your REAL inflation figure is, go to your checkbook and tally up what you are actually spending each year for taxes, utilities, insurance, food, postage, gasoliine, and the biggie - money spent on health insurance and doctors.  Being retired, I have the time the do such mundane things, and have found my personal rate of inflation over the past five years is AVERAGING around 8 percent !  Some years, it has been as high as 12% owing to local real estate tax increases and the exhorbitant increases in health insurance costs.  Don't believe these figures ?  Spend some time using your own checkbook data and you will see that your personal rate of inflation is double or triple the oft quoted "Core Inflation Rate" provided by the govt.  Think... just what monthly expense of yours has gone DOWN lately ???????
theteach   |     |   Comment #9


I agree I think we are in a bear still. The trend is still lower and I'm looking at P/E's and they are still moderate. The market P/E is also moderate at 17. I think we need to get to overall single digit P/E numbers before we hit a new bull market. Could be some time before we see that. In that case, cash is me.
Fixed Annuity Guy
Fixed Annuity Guy   |     |   Comment #14
Very good post..thank you

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