My experience has been that people naturally gravitate toward two camps when it comes to getting invested. The people in the first camp are rightfully focused on their careers and their families. They diligently sock money away, consciously spending less than they make, until one day they look at their bank statement and think, “Wow! That’s a lot of cash just sitting around!” The hurdle now facing these individuals is inertia—after all, if you haven’t done something about the money for months, what’s a few more days … or weeks … or months? Also, by this point you are typically talking about a large sum of money. And that can be intimidating in decision-making.
The people in the second camp love to see their money work for them. When they get cash inflow—from selling a script or a house, for example—they want that money to get invested right away and start earning more money toward their goals. The challenge here is making sure you aren’t making short-term decisions in a long-term game. Oftentimes, these individuals may need some of that money later in the year for special expenses or taxes.
We believe that the better approach is a middle path—a deliberate, disciplined approach that helps overcome the allure and burdens of inertia but doesn’t leave you so narrowly focused on maximizing return that you assume too much risk and end up with a negative investment experience.
Step 1: Build Your Cash Cushion
We would argue that the first rule of stock investing is that you should expect to be able keep that money invested for five years. Of course, we all know that things happen and circumstances change. Enter the cash cushion.
A cash cushion gives you some extra padding for unexpected changes in your financial situation, like a project timeline getting pushed out, a WGA strike or a large, unexpected medical bill. On one hand, having a cash cushion means sacrificing stock-like returns for that portion of your wealth. But you gain an important tool to manage or adapt to a change in your finances without having to immediately dip into investments. Time bought can afford you the opportunity to seek out a new job, secure an additional credit line or maybe just give you peace of mind during an already difficult time in your life.
In general, your cash cushion should provide for anywhere from three to 12 months’ average expenses. Where you fall in that range is going to depend on your situation and is a conversation worth having with your advisor. If your income is consistent and your skills are readily transferrable (like lawyers, for example), you may be very comfortable keeping three months’ expenses. But people with lumpy cash flows (like feature screenwriters) may need 12 months’ expenses to give them the ability to focus on the most fruitful projects.
A tip: Annual credit card statements can be hugely helpful in starting to get a handle on your average expenses if you don’t have a business manager who is already tracking that for you.
Step 2: Increase Your Cash Cushion
Your average expenses may not capture upcoming one-off expenses that are important to you, like buying a car, remodeling your kitchen or taking a big European vacation. Sure, you could make some extra money in the interim while you wait for the bill. But you could just as easily lose money and have to sacrifice to finance a goal for which you rightfully planned and saved. A specialized strategy using short-term bonds is likely a more prudent choice for earmarked monies.
This is also when it helps to regularly check in with your tax advisor, especially if you have a loan-out corporation or recently sold a big investment. In these cases, the cash you see in the bank might not all be rightfully yours for keeping.
Step 3: Develop an Investment Plan for the Excess Cash
Your cash cushion is priority number one. If you don’t have an adequately sized cash cushion in place, focus on getting that built before you start thinking about investments.
Provided you’ve already met that goal, your target investment amount should be any cash in excess of your cash cushion. Depending on the dollar value, you might want to make your investment purchases over several days or months rather than putting all the money to work on day one. Talk to your financial advisor about whether this may be an appropriate strategy for you to manage risk.
Step 4: Create a Plan to Invest Future Cash
For some investors, it may make sense to do this exercise once a quarter or twice a year to identify excess money for investment. For others who have large excess cash flow and fairly predictable incomes, it may make sense to try to forecast your excess cash flow going forward and start making regular (monthly or quarterly) contributions to your portfolio.
To figure out how much to invest on a go-forward basis, look at your monthly income and then subtract out your average monthly expenses. You won’t be spot-on in every month, but your cash cushion should help you navigate any shortfalls in a given month. Just keep your eye closely on the cash cushion—if it starts dwindling, you’ll want to suspend your monthly contributions until you catch up.
After this process gets ingrained, investing becomes integrated in your household finances just like paying your mortgage—we call it “paying yourself first,” and it’s a great habit to put you on track for your future goals and retirement.