On paper, financial planning is pretty straightforward. But in reality, it gets complicated. Not because of math or complexity but because our emotions get involved. When inflation and interest rates are rising and the markets get rocky, it's easy to let doubt about your investment plan creep in.
The good news is that there are ways to work around some of the roadblocks to investing that your brain may be putting in your way. Consider thinking about your financial picture in terms of 3 broad categories: emergencies, protection, and growth potential. These 3 building blocks work together to help make sure you have money for unexpected expenses, insurance to protect your income and home, and growth potential to reach your long-term goals.
Compartmentalizing your money like this can help you stick to your long-term investment plan. The emergency fund would ideally cover any unexpected needs that crop up in the short-term, and your protection strategy helps you to feel secure so that your growth bucket can get, and stay, invested.
2 reasons compartmentalization can work
1. It helps put goals into a manageable perspective. "Research suggests that people may be more likely to reach their goals when they are smaller and achievable. If we convert a challenging goal into smaller sub-goals, taking a step forward may feel more manageable," says Huma Khan, director of behavioral economics at Fidelity.
Saving for retirement sounds like a huge mountain to climb but aiming to save an amount equal to one year's salary by age 30 or 3 times your salary by age 40, is an example of a goal you can get your arms around more easily.
2. It keeps goals vivid and specific. "The common phrase out of sight out of mind applies to your goals, too. Don’t lose sight of your goals, and make sure they are clearly defined. We are more likely to try harder and engage in planning for our goals when they are salient and clear," says Khan
Being very precise and intentional about the way you treat your financial goals also helps. If all your money is in one big account, with your daily spending money sloshing around with savings and your emergency fund, things can get fuzzy and you're more likely to dip into cash you planned to save. But once money has been allocated to a specific goal, there's an added level of mental resistance to spending it.
Giving each goal its own space can help keep the significance clear in your mind. It could be a column in the spreadsheet you use to track your progress, an envelope you use for saving, or an account at a financial institution. To make it particularly powerful, consider adding a descriptive, emotionally meaningful label.
As an example, if you have a savings account set up for a down payment on a house, labeling the account something specific and meaningful to you—like "future dog yard" or "where my kids will grow up"—can help you stick to your plan.
Consider creating your goals in Fidelity's plan summaryLog In Required. You'll be able to add as many goals as you like, set the time frame, and track your progress.
3 elements of an investment plan: emergency, protection, growth
A healthy investment plan contains 3 components: liquidity for emergencies, as well as protection for those that you love, and growth potential for the future.
1. Emergency fund It makes sense for everyone to have some money set aside for the unexpected. While 3 to 6 months' worth of essential expenses is a good starting point, it's important to decide how big your emergency fund should be so that you can sleep at night. Saving 3 to 6 months' worth of essential expenses is a big goal to aim for so if that seems out of reach, $1,000 or enough to cover 1 month of essential expenses is a manageable milestone to aim for while working to save more.
Read Viewpoints on Fidelity.com: Preparing for emergencies
2. Protection Protection is a critical piece of a financial plan. It includes foundational pieces like life insurance, which provide protection to your family if you were to pass away unexpectedly. It also could include protecting part of your money from market risk. Principal protection strategies may include fixed-rate investment strategies for avoiding risk with a portion of your assets. Protected growth strategies exist to transfer some of that market risk, and income protection strategies are available to bolster your retirement income plan.
As your life and financial situation scale up in complexity, often as you get older and hopefully become more financially comfortable, the layers of protection you may want could extend to long-term care insurance and tax-efficient inheritance strategies.
Read Viewpoints on Fidelity.com: How long-term care planning can help your loved ones
3. Growth Once you've accounted for your emergency fund and protected certain aspects of your life, the growth portion of your plan is where you would put your diversified investment strategy. This component is generally the largest piece of your plan.
Growth potential can help your money keep up with inflation and (hopefully) help you accumulate wealth while staying invested through up and down markets. The key is to strike a comfortable balance between the level of stock market risk you can live with that also lines up with your time horizon, financial situation, and risk tolerance, and that provides the growth potential to meet your goals.
Knowing that you've filled up your emergency and protection buckets can help you stay more disciplined with your growth strategy.
Read Viewpoints on Fidelity.com: How to start investing
Where to go from here
Breaking down your financial life by category and assigning a broad goal to your assets can help you see how the pieces work together. Each bucket has an important role to play and that can help give you peace of mind when the stock market gets choppy. Knowing that you've planned for contingencies and have a cash buffer can help you stay invested through market ups and downs. It also provides ready cash for unexpected expenses so the rest of your plan can stay on track.
Once you have a solid grasp of how your money fits into these broad categories you can work to build each one up to fit your needs. For instance, you may feel a little nervous about investing in the stock market so it could make sense to have a more robust emergency fund so you feel more confident that you can ride out a market downturn and have cash available when you need it. In a similar way, life and disability insurance can help protect your family against a loss of income.
You don't have to do it all alone though. For more help, consider working with a financial professional to build your plan.