As I’ve noted in a previous blog, I like to break down where money goes into four buckets: Live, Give, Owe and Grow. Today, I’m going to expand on that concept by introducing the five sub-categories to the Grow bucket that make up your sequential investing hierarchy.
Let’s start with the assumption that your financial house is generally in order and you’re currently focused on saving and investing. Next, let’s assume you receive an influx of cash — maybe a bonus, an inheritance or vesting restricted stock units (RSUs). How do you incorporate this larger than normal sum of money into your overall financial picture?
You could spend it on a vacation or new car, but let’s make another assumption: you’re committed to making this money work for you. Most people fall into two camps; some opt to leave it in cash out of fear and confusion, while others eagerly plow it into a high-risk fund or new investment opportunity. Clearly, both are extremes, but without a framework it’s difficult to know what the other options are.
In an effort to make the best use of some unexpected cash, I recommend using a type of checklist approach so you know exactly where the money should go. While it’s tempting to jump ahead and invest money right away, using this framework — a sequential investing hierarchy — will help build wealth in the long run.
1. Eliminate short-term or high-interest debt. This level is your consumer debt — anything with a timeline of three years or less — and your credit card debt, which can take a long, long time to pay off if you’re carrying a balance.
2. Strengthen your emergency fund. You’ve probably heard it’s a good idea to have three to six months of living expenses available for a rainy day. I tend to play it safe and suggest you aim for six months, like I do, ensuring you have cash on hand for your total expenses during that length of time. Since the goals of this level are to maintain principal and flexibility, your options include money market funds, high-yield online savings accounts, and even short duration CDs.
3. Save for a major purchase. This level can be anything you consider major, but what comes to mind for me are car purchases, vacations and down payments to buy a home. The time horizon for major purchases certainly varies, so your options vary as well; anything from money market funds to a range of moderate risk mutual funds may make sense.
4. Diversify to meet long-term needs. This level consists of common goals like college savings for kids, building your retirement accounts or striving for financial independence. Often, this is where the higher risk investments lie, so many people are tempted to start here instead of on the first level.
5. Participate in high-risk activities. This level includes investing in venture capital, hedge funds and private equity — all actions considered to be high-risk/high-reward.
The goal of using this hierarchy is to eliminate levels one and two before you move on to the higher ones. Because it’s common to have multiple and competing goals, when it comes to levels three, four and five, using a ratio approach is certainly appropriate — allocating a certain amount to each as you see fit. Ultimately, your efforts will build on themselves and the reward will be the sense of freedom you experience from knowing you’ve taken care of each level in a methodical way.
Feel free to contact me if you’re interested in learning more about how you can benefit from using a sequential investing hierarchy. Think of it like a tower of champagne glasses — the ones at the top need to fill up before the bubbly gets to the ones at the bottom.
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