We do not collect all savings for one purpose. Let’s divide them into three groups – short-term savings in the event of a crisis, medium-term savings for larger purchases in the near future and long-term savings, whose task is to build our assets and secure the distant future.
Savings in the crisis fund
How much should our savings in the crisis fund amount to? If we assume the loss of a job and current income as the biggest crisis that can happen to us, the appropriate level of security should ensure us savings equal to approximately one year’s cost of living. Why?
The data from the Central Statistical Office show that a typical unemployed person is looking for a new job for about 12-13 months. It is worth preparing for this type of break in the inflow of new funds, especially if our education and skills are not sought after in the labor market.
The specific amount depends on our current expenses, commitments and standard of living that we would like to maintain. In crisis situations, most people are ready to lower their expectations, for example by reducing consumption, but there are limits to tightening the belt.
Therefore, savings in the amount of roughly the annual cost of living (own or family’s) at a basic level is a solid financial barrier against the impact of various crises that regularly occur in life.
The descent with free cash below this ceiling should serve as a cautionary signal. The stronger, the more our security buffer shrinks.
When it comes to medium-term savings, the sense of accumulating them is completely different. It is cash that we collect for a specific purpose, e.g. buying a car, vacation or renovation of an apartment. If we do not want to use loans and credits for this type of expenditure, there is no other way – we must save first.
Of course, the optimal level of this type of savings depends only on our needs and plans. The key to successfully financing larger expenses from savings will be the ability to systematically build the required capital over time. A permanent transfer to a savings account or deposit may be a useful tool.
The most difficult to assess is how much our long-term savings should be, i.e. those from which we will pay for children’s educational expenses in the future or from which we will derive income after finishing work. The simplest answer is – as much as possible.
This group may include not only cash, but also other, less liquid assets of relatively durable value, e.g. real estate, investment fund units, shares, bonds, and even pension rights. All this can be a source of income in the future.
It is quite difficult to talk about optimal amounts of long-term savings, but one thing is certain. As we age, our assets should gradually increase, and the first long-term assets should be acquired shortly after starting work.
Otherwise, from year to year, we will have to postpone an increasing part of our current earnings to make up for the lost time and allow compound interest, the main driving force behind long-term savings, to work.
So how much should our savings amount to? To carefully protect against unexpected crises, it is worth striving to accumulate and constantly maintain the equivalent of annual expenses on a savings account or its equivalent.
Medium-term savings are a derivative of our plans and needs. In long-term savings, the more we accumulate and the sooner we start, the better.