More Straight Talk on Investing. John J. Brennan

      But what about the “good life”? Don't savers miss out? No, they don't. They simply gain control. Living the good life isn't just about material possessions—it's also about possessing financial flexibility and broadening your options, and, importantly, about having things to which to look forward. Accumulating capital is the reward if you choose saving in the saving/spending trade-off.

      If you have a job and are earning money, the most fundamental financial planning question is this: Are you going to spend it all on current needs and wants, or will you set your living standards below what you can afford so you can save some of what you earn? Even if you can afford many things, the reality is that you cannot afford all of them. Before you decide how you'll spend your paycheck, decide how much you want to be setting aside for saving and investing.

      Two additional thoughts on saving:

      1 It's never too late to become disciplined about saving, but the sooner you develop the saving habit, the easier it will be to achieve your goals.

      2 It's a good idea to reevaluate your savings habits from time to time, particularly when going through major transitions in life.

Think of Your Financial Needs as Imaginary Buckets

      One of the most useful concepts in financial planning is to think of your financial needs as “buckets.” The idea is to determine how your money needs to be divided among the buckets, and then be very disciplined about filling those buckets. These are typical buckets of most people:

       Current expenses. This is what you live on—the money you use for your mortgage or rent payments, food, clothing, car payments, and other essentials.

       Emergency fund. Many experts recommend that you have six months' worth of take-home pay available to meet unexpected difficulties, such as a short-term layoff from your job or large expense.

       College. The cost of a college education keeps climbing, and though you can take out loans, you'll come out ahead if you can pay for as much of it as possible out of savings.

       Retirement. Many Americans today spend a quarter century or more in retirement. You can't count on Social Security payments as your sole support for all those years. Most people will need to draw on their own savings to live comfortably while they continue to pay taxes, medical insurance, and everyday expenses.

       Other goals. Add as many buckets as you want for other savings needs, such as replacing your car, buying a first or second home, taking care of elderly parents, giving to charity, or anything else you deem essential.

      You'll note that I've included charitable donations to the other goal bucket. At the risk of sounding sanctimonious, my personal view is that giving is important, and I encourage you to build it into your financial plan. Anyone who has accumulated money to invest should be willing to give something back to society. You don't have to be wealthy to give to a house of worship, the local fire department, your alma mater, or national fundraising organizations that serve your community or the broader world. Even small contributions can make a difference when they are combined with those of other givers. And they will make a difference in your own life, too. As my wife and I have increased our giving over the years, we've found it deeply satisfying to be supporting programs to help others, and we're most pleased that our children have adopted this same point of view.

Once you have designated target goals for each of the buckets in your financial plan, you will need to think about where you will keep the money. The idea is to maximize the return for each bucket within the parameters of your time horizon and risk tolerance. As a result of the varying issues in each situation, different buckets will call for different approaches.

Saving for Short-Term Needs

      You need immediate access to the money to meet current expenses, so you would eliminate long-term investment vehicles like stock funds and long-term bond funds from consideration. A rule of thumb in investing is that you should not invest money in stock funds that you will need in less than five years. Most people use a checking account for the money that's needed to meet current expenses. That's typically a checking account that pays little or no interest, so the trade-off for the convenience of this account is that you are earning virtually no return.

      Your rainy-day fund is a slightly different issue. Since this is money that you don't plan to touch except in an emergency, leaving it sitting in an interest-free bank account makes no sense whatsoever. A better choice would be to invest it in a money market fund, an ultra-short bond fund, or short-term Certificates of Deposit, which offer some return while still being relatively liquid, or readily available should an emergency arise. Such a choice will enable you to make your money work as hard for you as possible. If interest rates are low, you may wonder what the fuss is over a return of 1% or 2%. But ask yourself a simple question: Would you rather have the 1% or 2% in your pocket, or let the financial institution have it? Small amounts of interest eventually add up to impressive sums. Suppose you put $10,000 in a savings account that pays 2% a year, and it sits there untouched for 25 years. It will turn into more than $16,406.

Saving for College

You'll face a different set of considerations with mid-term financial goals. College is one of the most interesting investment planning issues because of the special considerations involved. We can all hope that our children will receive full or partial scholarships, or generous financial aid. But, realistically, most of us need to plan on paying for college either out of savings or with loans. And it makes more financial sense to be able to pay for it out of savings than for either you or your child to take on considerable debt. Start saving early, and time can help you foot the bill. College will be a more manageable expense if you finance it with savings that have compounded over the years (particularly if they compounded in a tax-advantaged account) than if you take on debt and pay off the loans and interest with out-of-pocket money. When you save, compounding works for you. When you borrow, it works for the lender.

      Your college savings bucket will require more active monitoring and management than the others for two reasons. First, you can already figure out when you're going to need the money and roughly how much you may need. If your child is 5, it's reasonable to assume that college bills will start arriving in 13 or 14 years. You can look at tuition data now and forecast what your costs could be for a private or public college. Tuition data are available from a number of sources, including the College Board's website (www.collegeboard.org). Given this information, you'll want to keep an eye on your college-savings bucket as time goes by to make sure it is moving you toward your goal. You may have to increase your savings, for instance, if you determine you are falling short.

      The second reason for actively monitoring your progress in saving for college is the relatively short time frame. Suppose you begin saving on the day your child is born. You'll probably want to start out with stocks because they are likely to offer more growth. But that growth offered by stocks is accompanied by considerable ups and downs over the short term, and you don't want to have to start using those funds for tuition during a prolonged down period. So, as your child enters her teens and college approaches, it may be prudent to shift into more conservative investments, such as a money market fund and a short-term bond fund, that emphasize preservation of capital while paying some level of income. My colleague Glenn learned this lesson the hard way when one of his children reached college age during the 2008–2009 market drop, and he had failed to adjust the child's college portfolios to a more conservative stance. It pays to pay attention.

      Note that many 529 plans, discussed in more detail in the accompanying Baseline Basics, offer age-based or target enrollment portfolios. You simply select the portfolio that matches your child's current age or expected matriculation date. The portfolios are diversified among stock, bond, and cash investments; the allocation then automatically and gradually adjusts over time to a more conservative mix as your child approaches the first day of college.