The sequence of events is consequential when we cook a meal, tell a story or travel to a destination. Instructions and directions are ordered, stories have sequential acts and arcs that depend on events. It’s the way things are, we accept this.
The same thing is true in the world of saving and investing. The chronology for both how you save (and invest) and where you save (and invest) matters.
Part 1: Save and Invest; Spend the rest
Consider leftovers. They are what is left after and not what is set aside in advance. People tend to view saving and investing the same way - what is left over after spending. If any remains, it is what gets saved and invested. When we save something for later, it’s often an afterthought.
Change the sequence of how you save by setting aside 10-30% of every dollar you earn to save and invest. The benefits are twofold: you'll save and invest more often because you prioritize this first and you will increase the total amount of your savings and investments instead of using what's merely leftover. Plus, there’s a bonus benefit: you can enjoy what you're spending knowing that you've already saved for the future.
Saving and investing first is one of the most valuable habits you can build into your financial life that has an outsized impact on your financial well-being. It's like brushing your teeth or stretching your body every day. The return on those behaviors is much greater than the cost and effort of doing them.
Part 2: The waterfall of savings and investing accounts
Think of your savings like a champagne waterfall. The bottle of champagne is the money you are setting aside to save and invest. Each glass in the waterfall represents a type of account with its own financial goal. Start from the top, funding the first account. When the account reaches its limit because it is fully funded or reached the limit for the amount you can legally put into it (retirement accounts have a limit to how much you can put into them each year), move onto the next account.
Your emergency fund is first.
Your emergency fund is your first priority because it'll be your first line of defense in the event of a financial shock. General financial wisdom says you should save three to six months of expenses saved in an emergency fund. Post-pandemic financial advice has changed to twelve months of expenses. As much as I love to hate on traditional financial wisdom, these benchmarks are solid, sound advice; financial shock should be expected and is not a matter of if but when in these tumultuous days. They're a guideline based on generalized risk, but choose based on your personal comfort. For some, saving six months is plenty. Others might require twelve months of reserve or more to sleep soundly at night. An emergency fund is made up of liquid assets (cash) you can access quickly, without penalty, when times require.
Retirement is next.
After you've funded your emergency fund, a common thing to start saving for is retirement. The sooner you start investing for retirement, the longer you have to grow your money through compounding. Compounding requires time for it to grow money exponentially.
Caveat: Yes, you might save for your emergency fund and your retirement account at the same time. Especially if you have an employer-sponsored retirement plan like a 401(k) with an employer match. An employer match means your employer will match a portion of what you contribute into your account. For example, if you put in $500, they will also put in $500 to match your contribution. You most definitely want to take advantage of this benefit because it's "free" money. Where else can you earn a 100% return on your money which is another way to think of “free” money.
Be cautious to only contribute what you can afford. I've seen plenty of folks nearly max out their retirement every year while going into debt because they don't have enough cash on hand.
What if you've topped off your emergency fund and made significant contributions to your employer-sponsored retirement account and still have champagne to pour (money to save)? Consider contributing to another type of retirement account like a Roth or Traditional IRA.
Remember the IRS caps the amount you're allowed to contribute across all your retirement accounts. You can google this shit and read up on contribution limits on the IRS website to familiarize yourself with these limits. I highly recommend talking to your accountant for tax counseling, this will keep changing over our lifetimes and it’s important to stay up-to-date.
Beyond retirement. Anything else?
Traditional financial advice preaches that we ought to be maxing out all possible retirement account options, period. I can't hate on this advice, but I understand that some people are still trying to earn enough to afford to make some contribution. I also understand the reality of life and trying to reach multiple financial goals at the same time.
After you max out on retirement accounts, the way you save and invest your money depends on your goals. Your goals could be anything from traveling to owning a home and raising 2.5 kids, and attempting to fund 2.5 college funds. The sequence for how you save and invest is a function of how much money you can save, how much money you need, and when you will need access to those funds.