How much should you invest - the Goldilocks Rule

I'm currently engrossed in James Clear's insightful book, "Atomic Habits." In a recent chapter, Clear introduces the fascinating concept of the Goldilocks Rule for habit formation. This principle suggest that individuals are more likely to abandon habits that fall on either extreme of the difficulty spectrum - those that are excessively challenging or overly simplistic. Clear's argument is that people naturally gravitate towards activities that hover just at the periphery of their current capabilities - tasks that are neither overwhelmingly difficult nor boringly easy. This sweet spot of challenge is what gives the rule its "Goldilocks" moniker, reminiscent of the classic fairy tale where the protagonist seeks the perfect balance.

Interestingly, the realm of personal finance harbors a parallel concept, particularly in the domain of investment risk-taking. The Goldilocks rule of investing advocates for a carefully calibrated equilibrium between risk and potential reward. It's a fundamental tenet in finance that generally, the higher the risk an investor is willing to shoulder, the greater the potential returns they might reap. However, this relationship isn't linear, and finding the right balance is crucial.

Building on this concept, I believe there's yet another application of the Goldilocks Rule that's particularly relevant to personal finance - determining the ideal amount to invest. This application seeks to find the 'just right' investment level that balances current financial needs with future financial security.

In my latest publication, "Stress-Free Finances," I propose a guideline of allocating 15% of your take-home pay towards investments as a solid starting point. This benchmark serves as a balanced target that can help many individuals build substantial wealth over time without overly constraining their current lifestyle.

It's crucial to note, however, that the true 'Goldilocks number' for investing is not a one-size-fits-all figure. It's a highly personalized metric that fluctuates based on your unique financial landscape. Factors such as your income level, living expenses, debt obligations, short-term financial goals, and long-term aspirations all play pivotal roles in determining your optimal investment rate. What might be the perfect amount for one person could be insufficient or excessive for another.

To help you navigate this complex terrain and pinpoint your personal Goldilocks investment rate, I've developed a comprehensive, step-by-step approach:

Determining How Much You Should Invest

Step 1: Ascertain Your Discretionary Income

The foundation of this process is creating a detailed, comprehensive budget. Understanding your discretionary income - the money left over after accounting for all necessary expenses - is crucial in determining how much you can comfortably allocate to investments. If you haven't already established a budget, now is the perfect time to do so. This exercise will provide invaluable insights into your financial situation.

When constructing your budget, it's important to factor in any existing investments you're making. This includes contributions to retirement accounts such as 401(k)s or IRAs. These are often overlooked but form a significant part of many people's investment portfolios.

Step 2: Prioritize Other Financial Objectives

While I may not align with all of Dave Ramsey's financial philosophies, there's one point on which we find common ground: it's generally inadvisable to prioritize investing if you're lacking an emergency fund or burdened with substantial high-interest debt. These financial elements form the bedrock of financial stability and should typically be addressed before ramping up your investment efforts.

However, it's worth noting that there's an important exception to this rule. If your employer offers a company-matched investment plan, such as a 401(k) with employer contributions, it's often beneficial to participate in these programs even if you're still building your emergency fund or paying down debt. The potential for 'free money' in the form of employer matching can provide a significant boost to your long-term financial health.

Step 3: Initiate Your Investment Journey

Don't let perfection be the enemy of progress. If you find yourself unable to immediately hit the 15% investment benchmark, don't let that deter you from starting. The key is to begin investing with whatever amount you can currently afford, rather than postponing until you can meet a specific target. This approach leverages the power of compound interest, allowing even modest initial investments to grow substantially over time. Remember, every dollar you invest today has the potential to work for you in the future.

Step 4: Establish a Concrete Retirement Goal

Determining how much to invest becomes significantly easier when you have a clear goal in mind. Through my complimentary financial planning service, I assist clients in calculating the amount they need to have invested by retirement to meet their desired income goals. This process is comprehensive and takes into account various factors including inflation rates, projected investment returns, and the client's target retirement age.

Setting a specific retirement goal is invaluable as it illuminates any potential shortfalls in your current financial strategy. If you identify a gap between your projected savings and your retirement goals, you'll need to explore ways to increase your investments over time or adjust your expectations for retirement income. This foresight allows you to make informed decisions and necessary adjustments well in advance.

Step 5: Exercise Spending Discipline

While this step might seem even less appealing than adhering to a strict budget, it's absolutely crucial for achieving long-term financial peace of mind. Controlling your spending habits is often the key to unlocking your investment potential.

I've come across numerous reports indicating that between 50% to 60% of individuals proportionally increase their spending when they receive a pay raise. Here's the pivotal insight: as your income grows, resist the temptation to increase your spending at the same rate. Instead, channel that additional income into your investments. This strategy, often referred to as "avoiding lifestyle inflation," can dramatically boost your investing power without feeling like a significant sacrifice in your day-to-day life.

By incrementally increasing your investment contributions as your income grows, you'll find yourself steadily approaching - and potentially surpassing - that 15% benchmark. It's important to remember that the Goldilocks Rule isn't about achieving perfection; it's about finding the right balance for your unique situation and consistently working towards your financial goals. This approach allows for flexibility and growth, ensuring that your investment strategy evolves alongside your financial journey.

Ok, if you’ve made it this far, I should take this opportunity to point you towards my latest book, Stress-Free Finances. In it I share 25+ years of experience in personal finance, where I teach you everything I know about creating a stress-free financial life.