We know how investing is different from just saving. If we put our saved money somewhere where it will grow, then that's investing. However, there are a number of possibilities available when we want to invest, and it isn't possible to make sensible choices without having a way to classify things.
However, let's not jump into classifying investments right away. Before we do that, we need to classify our need for making an investment. Investments can be made for a huge variety of needs. You could be saving for emergency medical funds which are usually required at a moment's notice. Or you could be saving for your retirement which is a few decades away, or anything in between.
We have created a useful framework for thinking about these investment needs. We divide investment needs into four levels. Each level is more fundamental than the ones that come after it. You should satisfy the need at each level before going on to the next one.
Those who know a bit about psychology may recognise this system as being based on the 'Hierarchy of Needs', a concept proposed by psychologist Abraham Maslow. Maslow's hierarchy dealt with basic human needs like food, shelter, etc. Basically, human beings deal with their higher needs after the simpler ones are satisfied.
So here's Value Research's Hierarchy of Investing Needs:
LEVEL 1: Basic contingency funds
This is the money that you may need to handle a personal emergency. It should be available instantly, partly as physical cash and partly as funds that can be immediately be withdrawn from a bank. Online banking and ATMs make it relatively simple to get this organised.
LEVEL 2: Term insurance
Calculate a realistic amount which allows your dependents to finance at least short and medium-term life goals if you were to drop dead or be struck with a debilitating injury or disease. You should have an adequate term insurance before you think of any savings.
LEVEL 3: Savings for foreseeable short-term goals
This is the money needed for expenses that you plan to make within the next two to three years. Almost all of this should be in minimal risk, deposit-type savings avenues.
LEVEL 4: Savings for long-term foreseeable goals
Same as level 3, except the planned expenses are more than three to five years away. This level should be invested in equity and equity backed investments like equity mutual funds.
One could think of many levels beyond this and really, the details matter much less than the concept. Depending on one's circum-stances, any of the levels may have to be modified. For example, you may have enough income-producing assets to make insurance relatively less important.
However, this doesn't decide how much to invest in each need. This system aims at preventing you from going to higher level unless the lower one is fulfilled. If you haven't put emergency cash in a savings account, then don't buy term insurance. If you don't have term insurance yet, then don't start putting away money for your daughter's college education, and so on.
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