How To Set Financial Goals
2/6/2010 12:28:56 PM
From The Zen Investor online edition

Getting Started

Setting fiancial goals is one of the hardest parts of the investment process.  Many financial professionals - brokers, advisors, planners - assume that you come to the table with your financial goals already figured out.  But what if you are stuck at this key point and can't figure out how to move forward?  How do you decide which goals are the most important and which ones can be postponed?  Here's a relatively simple way to get past the goal-setting hurdle.

First, take out a pad and pen and make two columns.  Label the first column "Short Term Goals" and the second column "Long Term Goals."  Next, under Short Term Goals list the things that you want to have before you retire.  Stick to major purchases like a house, a car, a college fund for the kids, a big vacation, or that expensive toy you've been dreaming about having some day.  Don't worry about forgetting something because this list will change as your life circumstances change.  Keep it simple and short.

Your short term goals are funded by your taxable savings, as opposed to your tax-deferred savings (401k plan, IRA accounts, or pension plan at work.)  Remember that we want to keep it simple.  Just estimate the dollars you need, and the date you will need them.  The last step is to figure out how much you need to save every month in order to make these short term goals happen.  Simply divide the cost of each goal by the number of months until you  want to accomplish them.  I know it sounds simplistic, but most people - the vast majority of people - don't even go this far in their planning.  By simply figuring out the cost, the time frame, and the monthly savings you need for each goal, you will be ahead of the curve in reaching them.

Next, under the Long Term Goals column, list everything you can think of as it pertains to your retirement.  There are other long term financial goals, like leaving a bunch of money to your kids, donating a wing at the local hospital, or establishing a scholarship in your name, but let's focus on retirement because it's the primary long term goal for most investors.

Under Retirement, start with your ideal age when you retire.  Be realistic, because most of us would like to retire at 40, and travel the world like free spirits.  But 55, 60, or 65 are more realistic, and we try to operate in the land of reality on this website.

Once you have your retirement age, calculate the number of years you have until you reach it.  This number becomes the key to setting up a savings and investing plan that will get you past the goal-setting hurdle.  This number will guide you through the maze of choices about how to invest, and where to look for relevant investment advice.  For a detailed discussion about how much you should be saving, and what to invest those savings in, see our article on Saving and Investing.


An Example

Setting financial goals may seem complicated and difficult, but if you start with a broad-brush overview you will quickly realize it's not that hard.  Don't stress over "getting it right" because you can always go back and revise your financial plan.  In the spirit of keeping it simple, let's take a look at some big picture examples.


Retirement

You need 2 pieces of information in order to set your retirement goal.  At what age would you like to stop working, and how much monthly income will you need in retirement.  Remember that the age you choose today can, and probably will, be revised several times as you advance through your working life.  So for the purposes of this discussion, let's assume a retirement age of 65.  The number of years you have between now and age 65 (or whatever age you choose) is your Time Horizon.  The next step is figuring how much monthly income you will need.

Retirement Income Estimate

In order to make the numbers easy, let's assume that you're currently making $50,000 per year, and you will be working for another 30 years.  Ask yourself this question:  How much monthly income would it take in order for me to enjoy a comfortable - but reasonable - lifestyle in retirement?  Today you're making $4,166 per month.  You probably have a good idea about how much more money it would take in order for you to live in the right place, drive the right car, and buy the things that you think would make you comfortable.  This is just a ballpark estimate, so don't worry about the details.  This number will change over time, and you will adjust your financial plan accordingly. Once again, in order to keep the math simple, let's assume you would like to make twice as much as you do now, which would be $100,000 per year or $8,333 per month.  This is your retirement goal.  


How Do I Get There

The next question is, how much will you need to save, and how fast will your savings have to grow in order for you to achieve this important goal?  It's not as complicated as you might think.  All you need to do is take your retirement goal number and "gross it up" to find your Final Nest Egg number.  In our example, we take $100,000 and multiply it by 80%, since it's a reasonable assumption that our monthly expenses in retirement will be lower than they are when we were working and saving for retirement.  Next we take $80,000 and divide it by 6%, which is a reasonable expectation of the rate of return we'll be able to lock in at retirement, and we come up with $1,333,333 as our Final Nest Egg, or the total amount we need to have in our retirement account at age 65.  How realistic is it that we will be able to accumulate this much on our modest income?  For an answer to this and other "how do I get there" questions, see our article on Saving and Investing.