Tuesday, June 05, 2012

Time Horizons for Investing in your Personal Finances

One of the most important skills, indeed, the most important skill when it comes to personal finance is the simple rule: Spend less than you make. This is a simple rule that works for handling all personal financial situations. If applied correctly and the wisdom that it imparts is correctly understood, it can determine the course of your financial future.

Personally, I am continuing to work on ways that I can spend less than I make. For this to happen, I need to accurately understand all of my expenses and all of my sources of income and determine how I can track it and ensure that I take steps until my income is larger than my expenses. I have reached this point many years ago and the progress has been positive since then and I consider myself lucky.

Now, I am proceeding down the path and I realize that there are two aspects to this constant quest--a shorter term aspect which consists of very specific steps that can be taken in the very near term. Then there is also a longer term view of this goal that I am currently involved in which causes me to do quite a bit of head scratching as I try to figure it out.

The short term and long term are different for everyone, so I understand that these posts will not be applicable for everyone, but as with nearly everything in personal finance, this is personal. I find that anything in the next month is short term. Our year is divided into twelve months, and personally, I find that this length of time is how far out I tend to make my plans for work, finances, and social life.

The long term for me tends to be between 12-24 months. This is because it becomes extremely difficult to forecast what will happen in my life in terms of life-changing events as well as with the economic situation more than a year out. I think that this is true of most people as well.

I personally believe that the likelihood that forecasts turn out as expected approach about 25% when they are for periods greater than 2 years into the future. For me, for that time horizon, or, put another way, this time tends to be an utter waste of time to do forecasting. Additionally, this time horizon tends to be the amount of time I have set aside within my emergency fund. That also provides a great deal of stability within my forecasts. After a disaster, I would have that period to be determining next steps.

The value of forecasting is that you can construct various worst-case scenarios and determine what your possible reactions would be in the short and long term:
- Job Loss
- Health loss/Injury
- Minor Car/Home Repair
- Natural Disaster

All of these scenarios (and probably more) should be considered and planned for both short and long term. But forecasting doesn't stop there; planning for both the short and the long term can impact your investing as well. Furthermore, the time horizon that you're focused on has a dramatic impact on the types of things that you will be doing to improve your overall financial situation, which can include a lot more than just your investments. I'll talk about these in two subsequent posts about short and long term plans.

No comments: