Prudent investments that offer steady returns are every investor's dream, and affluent individuals focus on investing their savings efficiently.
With current market uncertainty impacting confidence levels, it is important for investors to adequately gauge long-term investment risk. And one of the ways we do this is by evaluating the level of short-term cash reserves.
Setting aside enough cash to cope with market turmoil is a necessity that is often overlooked by investors: if markets are down and one needs to de-invest capital to pay the bills, one has no choice but to take the loss. And that immovable fact should determine longer-term investment strategy.
What is the amount of cash you should accumulate before you consider investing? The first place to begin would be your expenses. Estimate the amount you need to pay your creditors, and you know how long you can survive during difficult times.
This inventory will also make you aware of the impact of your spending behavior — a positive side-effect of your stress test.
Expenses can be categorised as monthly or annual. Monthly expenses include mortgage or rent, any form of personal loan, food and beverages, utilities and communication, and hobbies and sports. Annual expenses include insurance, holidays, school fees and replacement & maintenance costs. Your personal expense list for both categories can be built using your bank statement or invoice binder.
Having estimated your average monthly spend, you can determine how many months of expenses you should set aside. The general consensus is six months.
However, it is advisable to assess your personal situation: Is your job in a sector that is vulnerable to the impact of the financial crisis? Is your income diversified enough? What part of your income comes from returns on investment? What impact would a market downturn have on your total income? Are you currently on probation? Are your long-term investments liquid enough?
Answers to these will determine the savings total you need to set aside: Perhaps a full year of cash reserves?
So here's the test. Multiply your total monthly expense by the number of months you estimated. If your current cash position is lower than your calculated outcome, you didn't pass your stress test!
What to do?
Be careful with cards; they are not a cash reserve. Using credit cards as a monthly facility to enjoy cash-back benefits or air-miles schemes is fine as long as the entire bill is paid at the end of each month. Revolving, however, can make your cash reserves virtual and trap you when you are cut from income.
Put a standing order of at least 15 per cent from your current to your savings account, to put money aside without calculating it in your monthly budget. A balance sweep function at the end of the month helps you to make your savings efforts tangible.
Consult your financial adviser to choose the best rate. As with credit cards, there are more types of saving accounts than there are banks, and a well-informed individual will get you the best rate. Keep in mind, too, that online savings accounts usually provide better returns.
Start maintaining your own books. It is astonishing how much you save without noticing. A wide range of spreadsheets are available on the Internet and many of these templates are free.
Final thoughts
Often, fancy-looking short-term banking products appear very attractive. Beware that associated direct and indirect costs can erode your returns. Try to focus on inflation to keep the value of your money, and be practical with your assets. Remember: you are not just investing but building a buffer that will reduce future stress.
The writer is Head of Priority Banking, Emirates NBD. Opinions expressed here are the writer's own and do not reflect that of Gulf News.
