Saturday, February 4, 2012

Pay Yourself First

        Most of us have heard about the concept of paying yourself first, there’s a lot of confusion as to what it means when it comes to how much you should save and where it should go. The concept of “pay yourself first” is that the next time you earn a peso, before you pay anyone else any money they may have coming to them, you must pay yourself first.

        You might ask how can one “pay yourself first” when one’s salary can hardly make both ends meet. It is so crucial for you to live within your means. One of the great secrets to wealth accumulation is to discipline yourself to live on no more than 90% of your income so that you can allocate at least 10% of every peso earned to pay yourself first.

        In the book The Richest Man in Babylon, by George S. Clason, the richest man in Babylon (the wealthiest city in the ancient world) stated in a series of parables or stories intended to convey a message, this way:

“A part of all you earn is yours to keep. It should be no less than a tenth, no matter how little you earn. It can be as much as more as you can afford. Pay yourself first. Do not buy from the clothes-maker and the sandal maker more than you can pay out of the rest and still have enough for food and charity and penance to the gods.”

        The fact is that most of us pay everyone else before we pay ourselves. The first we pay is the government tax through our withholding tax. Then we usually pay the rent or mortgage and the rest our bills. If anything is left at the end of the month, then maybe we pay ourselves by putting a few pesos into a savings or investment account.

        To build wealth, you have to pay yourself first and decide to take action now and do it every month. Start by saving just 5-10% if that is all you think you can do it. And if you can work your way up, let’s say 15-20% of your income, you will automatically become wealthy. Let us say, if you’re earning P20,000 a month, 10% of which is P2,000. That should be the amount you have to pay yourself first for investment purposes.

        Corollary to this concept is the miracle of compound interest. It is the most amazing phenomenon Albert Einstein had ever come across. It demonstrates the power of saving a small amount of money each month and then letting it compound. Depending on the rate of return, investing just P1,000 a month and then letting it compound can quickly generate a surprisingly large nest egg.

Savings Growth of P1,000 deposited monthly

Interest Rate
5 years
10 years
25 years
40 years
3%
64,810
140,090
447,120
928,370
5%
68,290
155,930
597,790
1,532,380
8%
73,970
184,170
957,370
3,514,280
10%
78,080
206,550
1,337,890
6,376,780

        The graph readily shows how fast you will accumulate money because of “compounding interest.” In case you save P1,000 a month for 25 years at 10% interest, you will be a millionaire as your money will reach P1,337,890. At 40 years, it will P6,376,780. Where can we put the money at 10% rate of return? We’ll discuss this.

        The basics of pay yourself first are: (1) Make sure your money is invested for growth. In this rule, “asset allocation” will come into play. Asset allocation is the process of deciding how to divide your money among the three types of asset classes: stocks, bonds, and cash equivalents, such as time deposit, money market, etc. You make this decision based on your tolerance for risk and your time horizon. (2) Don’t borrow from your investment plan. The lesson should be clear. Leave your investment or retirement money alone until you are ready to retire.

        In the Philippines, there is a multitude of outlets that the investor can put his or her money into:

Short-term

  •          Savings Account, you can place the money in a special savings account that earns a much higher interest than a regular savings account.

  •          Time Deposits, like the Plantersbank Premium 5 which earns 6% interest for a 5-year term, etc.

  •             Commercial Papers

  •            Treasury Bills, if you want relative safety, place your money in short-term government securities like T-bills.

Long-term

  •              Bonds

  •             Stocks, you can buy shares of publicly-listed stocks in the Philippine Stock Exchange, such as SM Investment Corp, Megaworld, PLDT, Meralco, etc. So far, the best investment vehicle which can earn a higher return but a higher risk is involved.

  •           Mutual Funds, pool money from thousand investors for investment in bonds and stocks, i.e., Sun Life Prosperity Phil. Equity Fund, GSIS Kinabukasan Fund, Ayala Life Fixed Income Fund, Philequity Fund, Philam Fund, etc.

  •          Unit Investment Trust Funds (UITFs) are pooled funds that trust departments of commercial banks invest in various securities, i.e., Banco de Oro, etc.

  •           Insurance Plans, such as Whole life insurance plans which have a savings component.

        In the rule of “diversification” in personal finance, don’t put all your eggs in one basket. That means spreading your money across different investment instruments and different institutions. How much you allocate across different investments depends on your age, risks, and objectives.

        The absolute most important thing you can do to have a major, positive impact on your future financial security is to maximize your contributions to a retirement account and make sure the money works for you. Remember this: THE FOUNDATION OF WEALTH BUILDING IS PAY YOURSELF FIRST.

        More on our next topic on personal finance.

4 comments:

  1. If you're looking for money to grow over time on no risk medium yield savings, this is perfect advice. I agree with Atty. Darang, living within our means, in fact living below our means, i.e., cost-cutting efforts, would speed up and maximize our chances of building wealth via investments. What about a follow-up article on how to choose high-yielding stocks since they are corollarily also high-risk. For most of us with blue collar jobs, tips like these would help us avoid investments scams and pitfalls.

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  2. ok, in succeeding blogs...thanks for the comment.

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  3. Wonderful!. This is great rey, thanks for having this posted.

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