We are often told that we should allocate some of our income to savings. Some financial experts even come up with how much that allocation should be, and arbitrary numbers like 10% or 15% are recommended.
I have to say I don’t really understand this. How can they create a general rule about savings when all of us have a unique financial situation. And unless you know exactly what you are saving for, how can you decide how much to save? For all you know, you may just be better off spending some of that money now instead of keeping it for future.
Of course, there can be many valid reasons for which you should start saving. You may want to save for retirement, pay for your kids’ education, buy a bigger house, buy an expensive car, or do anything else that you want with your money.
For example, along with retirement savings, I also want to save for a long vacation abroad. Once I had this clarity about exactly what I’m saving for, it became much easier for me to prioritize my allocation of funds and make it more relevant.
Analyzing how much money you will need to achieve your goals
After you have outlined your savings goals, you need to understand how much money you will need for each of them. If you are saving for your kids’ education, find out how much the tuition fee for good colleges is and how much living expenses you’ll have to account for.
Keep a buffer
You would have to factor in some uncertainty in this calculation and it is always a good idea to keep a buffer. This is even more important when some of your savings are invested in risky assets like stocks. Don’t count on your investments giving you positive returns year after year.
Don’t forget about inflation
If you are saving for long-term goals like retirement, inflation is going to play a very important role in your calculations. Prices can change significantly every year and you cannot simply allocate funds on the basis of your current living expenses. The average long-term inflation in the U.S. is about 3%, and you can use this number to predict how much your expenses will be, say twenty years from now.
Once you have figured out how much money you’ll need and when you’ll need it, you can easily decide what percentage of your income should go into savings.