This article is part 3 in a series of articles meant to help scientists take control of their finances. Part 1, Financial Planning for Scientists, introduced the series and the concept of "start early, save more;" and part 2 Start Saving Today, offered tips on how to control your spending today so that you can save for tomorrow.
In the last two months, we've discussed why it is important for scientists to think about their financial situation, and we talked about some tips to make saving some money a little easier. Today, we're going to discuss setting your financial goals. We'll discuss figuring out how much money you need, and what you need to do to save that amount. We'll be using Microsoft Inc.'s Excel ® to help us out with some of the calculations, so you should open that program up and "play along" as you read on.
The first part of building your financial goals is to determine what they are. Let's start with a really simple example. Let's say that you only have one financial goal, and it is to go to Thailand in 3 years. You want to spend a month away from the lab--hanging out on the beaches, exploring the country, and learning the local culture. You've done some research on cost, and you've figured out that, in 2003, you'll need $2500 to do this. So far, you've got $300 saved up for this trip.
So, how much should you be saving each month?
Well, to start, you've got to look at how much your money is going to be making over the next 3 years. The percentage yield on your money is basically dependent on the amount of risk you want to take. Since this is a short-term goal, you'll want to put your money somewhere "safe," and because of that, you'll earn less interest on it. We'll talk in more detail about determining your risk profile, and building what's called "a balanced portfolio" later on in this series, but lets say, for now, that you know for sure that you can make 5% on your money, by investing in guaranteed investment certificates (again, we'll talk about what these are in a later exciting episode).
So, to sum up, you want to save a certain amount every month, in order to have $2500 in 3 years. You have $300 right now, and you know your money will yield 5% (compounded monthly because that's what the bank tells you).
Here's where Excel comes in handy. Specifically, a function called "PMT," for "payment." The function works like this:
PMT(rate, number of periods, present value, future value)
The program will calculate the monthly payment you'll have to save, if you give it all the other variables.
So, here, our interest rate per month is 0.42% (5% divided by 12, because we're making 5% per year). Our number of periods is 36 (12 months a year for 3 years). Our "present value" is $300, because that's the amount we've got today. Our future value is -$2500. Yep, that's NEGATIVE 2500. That's because we want to take OUT $2500 at the end of the 3 years.
So, in your Excel spreadsheet, you'd type in =PMT(.42%, 36, 300, -2500).
The program would return the number $55.48. That's how much cash you need to save every month.
The problem with today's exercise is that it's a bit theoretical. You know exactly how much money you need. You know when you'll need it. And you know how much interest you're going to get on your money. But that's OK. It's a start. We're just learning here.
What happens when you remove one, two, or three of these variables? Well, you're stuck in a situation where you have to guess. Here's another example.
Let's say you're saving up for a trip in 15 years instead of a trip in 3 years. In this case, you have NO IDEA how much the trip is going to cost. After all, things go up in price every year, don't they? So how much will a trip to Thailand cost in 15 years?
The answer: I have no idea.
But let's try to guess.
One way of guessing is by looking at inflation rates. Let's say we can find a study somewhere that says that both the cost of travel, and the cost of living in Thailand, are going to go up 2.5% a year for the next 15 years (compounded yearly).
Our calculation goes a little like this: If it costs $2500 to go today, it'll cost $2500 x (1 + 2.5%) to go next year, or 2500 x 1.025. If we were to go in 2 years, it would cost 2500 x 1.025 x 1.025, because year one's price would have to be adjusted again in year two. Thus, after 15 years, the amount you'd need to go to Thailand is $2500 x (1.025)15. Or $3620.
You can use the same calculation to figure out how much money you'll need at retirement: If you think you'll need today's equivalent of $350,000, in 40 years, then the calculation becomes 350,000 x (1.025) 40. If you do the math, it comes out to, well, a whole lot of cash. Scary, eh?
Armed with these two calculations, you can determine just about any financial goal. Play around with them. Now that you know how much you need, you'll be able to plan your financial future a bit better.
Of course, the trick is that interest rate, or "yield." The yield, as we will see in coming chapters of this series, has a lot to do with the risk you're prepared to take. It's a lot like gambling: Are you the person that bets on "red," because your odds of winning are the best, or are you the kind of person that bets on a number, knowing the odds are the worst, because the payoff is better? The more risk you are willing to take, and the more variation in yield you are comfortable with, the better you might be able to do. But if you want a sure-fire amount, with little or no risk, the guaranteed yield won't be as high.
The rest of this series will discuss all the different investment choices you can make to tailor your risk (and your potential yield). So stay tuned in the New Year!