Last week we talked about the most important principles to keep in mind while saving money in your twenties. The first thing we recommended you do, was to identify your savings goals.
For many people, setting goals seems like a logical way to approach saving. But we also meet customers who say, “Can’t you just tell me how much to save?”. Or “I don’t have any goals”. In this article we will tell you why goals are the foundation of our financial planning approach. And which ones you can start with if you don’t have any goals on your mind currently.
People who save for goals, save more.
Studies have shown that people who save for goals, save more than those who just save generally (about 15% more, according to this study from Morningstar). This is due to a behavioral phenomenon called mental accounting, which we discussed at length in a previous post.
Here is the long and short of it. People commonly think of their wealth or income in “categories” or “envelopes”. It is a simple way to keep track of their money. For example, you may divide your income into rent, eating out, savings etc. Research shows that people hesitate to move money between these envelopes. Goal-based saving turns this bias into a strength. Simply put, saving money for a specific goal makes it less likely that you will spend it for something else.
Goals tell you how much you need to save, so you can spend the rest guilt-free.
In our conversations with users, we hear a familiar story. People say they are happy that they are saving. But they worry if they are saving enough. Well, how much is really enough? This is a question goal-planning can help answer. By setting goals, and specifying when you want to achieve them, you can calculate how much you need to be saving for them. Once you’ve saved for the future, you can stop worrying about money, and enjoy the remainder of your income guilt-free.
Goals also help determine where you should save and invest.
The single most important factor determining where you should place your savings (e.g. fixed deposits, mutual funds), is when you to need the money. We will cover this in more detail in the future, but here is the main point. In the long run, equity mutual funds tend to outperform almost every other financial product, especially fixed deposits and saving banks accounts. But in the short-run, their performance can fluctuate quite a bit. We don’t recommend investing in them if you need your money back in the next few years. But how do you know when you need the money? The answer (you guessed it!) is: your goals will tell you.
Three goals everyone should have: an emergency fund, loan repayment and long-term investment.
We understand that many people, especially young people, don’t always have goals in mind. For them, we recommend they start with the essentials: paying down debt (especially credit card debt!), and building an emergency fund. Saving up for retirement or long-term wealth building is another great goal to start early on. These are extremely essential to have. Think of them as the vaccines you got as a child – slightly painful (and boring), but very useful in protecting you in the long run. More on this in the next post.
So, we hope we have convinced you to start your financial planning journey by identifying your goals. If you remain a skeptic, don’t let that stop you from saving. As we discuss in this article, just set yourself a savings target and get started.
Egan, D. (2017, May 24). 9 Reasons Goal-based Investing Leads to Success. Retrieved from the Betterment blog: https://www.betterment.com/resources/investment-strategy/behavioral-finance-investing-strategy/goal-based-investing/
Hammond, S. R. (2017, April 10). Goals-Based Investing: From Theory to Practice. Retrieved from Forbes: https://www.forbes.com/sites/pensionresearchcouncil/2017/04/10/goals-based-investing-from-theory-to-practice/#31011b88459d
Morningstar. (2015). Optimizing Savings with a Goals-based Approach. Retrieved from Morningstar: http://www.morningstar.in/posts/43045/goals.aspx
Samlad, R. (2017, September 22). The importance of goal-based investing. Retrieved from Morningstar: http://www.morningstar.in/posts/43045/goals.aspx
Shefrin, H. M., & Thaler, R. H. (1988). The behavioral life cycle hypothesis. Economic Inquiry, 26, 609-643.
Rha, J.-Y., Montalto, C. P., & Hanna, S. D. (2006). The Effect of Self-Control Mechanisms on Household Saving Behavior. Journal of Financial Counseling and Planning.
Shefrin, H. M., & Thaler, R. H. (1992). Mental accounting, saving, and self-control. In G. Loewenstein & J. Elster (Eds.), Choice over time (pp. 287-330). Russell Sage Foundation.
Thaler, R. H. (1990). Anomalies: Saving, Fungibility, and Mental Accounts. Journal of Economic Perspectives.