We have discussed in detail how to save for retirement, one of the biggest and most costly goals that you could have.  Now let’s talk a bit about other goals, such as buying a new car, taking a big vacation, saving for an engagement ring, a down payment for a house, or becoming financially independent.  

In essense, what you need to understand in order to reach any goal is the “time value of money”.  The basic principle behind time value of money is that one dollar today is worth more than one dollar that you will receive in a year, because you are able to earn a return on the dollar that you have today.  By learning how to do time value of money calculations (like we did when determining how much to save for retirement) you can determine just how much to save for any goal.

The steps we will follow are: 1) Determine how much the goal will cost in today’s dollars.  2) Decide when you would like to accomplish the goal.  3) Adjust the price for inflation.  4) Use a time value of money calculator to determine how much you need to save either in one lump sum now, or in monthly deposits, to reach your goal on time.  5) If the savings amount is unreasonable, adjust the goal accordingly by reducing the cost or planning on accomplishing it further in the future.

For example, imagine that two years from now, you want to spend a week or two traveling in France  You estimate that the trip will cost you around $4,000 if you booked it today.  Using a time value of money calculator and assuming an annual inflation rate of 4%, you can determine the cost of the trip two years from now:

t = 2
m = 12
r = 4%
PMT = 0
PV = 4000

Hit compute next to FV and you will find that the trip will cost about $4,332 two years from now, adjusted for inflation. It shows as negative, because the end result is “paid out” of savings.

Now, you can determine how much you need to save to reach that goal.  As mentioned, you have two options: to invest one lump sum now, or to save a smaller amount each month to reach your goal.  Investing one lump sum now actually requires that you save less money in the long run (because it has longer to compound) but can be difficult for large goals.  Using the time value of money calculator, we can determine what lump sum you would have to invest now to reach your goal in two years:

t = 2
m = 12
r = 6% *A rate you should be able to achieve with a very conservative cash investments (money market accounts or CDs)
PMT = 0 as you are investing a lump sum.
FV = -4332 Again, negative because it represents a withdrawal.

Hit compute next to PV to determine the lump sum that you would need to invest. In this case, $3843.79.

If you don’t have $3843.79 laying around, you could also save a smaller amount each month to reach your goal. To determine how much to save each month, use the following computation:

t = 2
m = 12
r = 6% *A rate you should be able to achieve with a very conservative cash investments (money market accounts or CDs)
PV = 0 as you are starting with no savings.
FV = -4332 Again, negative because it represents a withdrawal.

Solve for PMT to determine the amount you will need to invest each month. In our example, $170.36 per month and you’re off to France!

The same technique can be used to determine how to save for any goal.  The trickiest variable to consider is the prospective rate of return on your savings.  If the goal will occur in the short term (2-3 years or less), plan on investing in money market accounts or CDs and earning a relatively low rate of 4-6%.  If you have more time to save, you can begin to mix ETFs or mutual funds into the savings mix (SPY, for example) and increasing the rate of return.  If your goal is ten or more years out, you can afford to be pretty aggressive with your savings, investing in a mix of large cap, small cap, and foreign stocks or ETFs.  A software package like Quicken can be very helpful in determining what rate of return to expect from any given investment mix. 

Ben Stein is blunt about the most important tenet of saving to reach any goal, however: “If you don’t put money in, you won’t be able to get money out.”  So start socking those funds away, stop dreaming about your goals, and make them a reality!

Next time around, we will move on to the next step of The Plan: auditing your expenses to free up more cash to save and live on!

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This entry was posted on Tuesday, November 21st, 2006 at 8:00 am and is filed under "The Plan", Saving. You may e-mail this post to a friend. You may print this page. You can leave a response, or trackback from your own site.