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Setting your goals can be the most important component in your broader attempt at making smart financial decisions. When you start with your goals, you can get a sense of where you need to go and what steps you need to take in order to achieve them.
For example, do you want to live a comfortable lifestyle now, or sacrifice now for a comfortable lifestyle later? Is it important to have a new car? An expensive apartment or home? How can you save for travel to exotic destinations and save for retirement? Could you defer gratification today for a more comfortable financial situation down the road?
Now that you’ve set your goals, it’s time to review your budget to evaluate your spending. Do you see anything that doesn’t align with your goals and even runs counter to them? If so, you should immediately stop that spending.
Do you really need the deluxe cable package or entertaining friends and family in the best restaurants? Could you make some sacrifices in your spending habits if you knew it would hasten your wealth accumulation?
The concept can also apply to other financial decisions you make, like deciding how much to spend on a house, how much to save for education, the types and amounts of insurance you purchase and more.
Compounding is the process by which the interest generated by a financial asset is reinvested, creating additional earnings over time. The growth from compounding is exponential, as the principal and the accumulated earnings continue to grow.
The compounding effect can play an important role in your financial success. Especially if you start early and have the discipline to aggressively fund your investments. The critical factor here is time. If you studiously fund your savings and investments at an early age, you’re giving your money an additional advantage by allowing it more time to grow and compound.
But it also works the other way.
In your analysis of your spending, take the long view of just how much your coffee habit (for example) has on your money. If you spend $5 per day on a coffee, that translates to $1,825 over the course of a year. If you put that cash into compounding investments, it will grow at an exponential rate. Likewise choosing an apartment that costs $1,500 a month, instead of $2,000, gives you $6,000 in annual savings that—if invested—could be compounding for you.
Whether you’re just starting out or you have decades of experience, going it alone is never a good idea. Interview financial professionals about their investment strategies and review your financial goals with them. This is especially important in assessing your investment portfolio for proper diversification and alignment with your risk profile (your aversion to financial risk).
When you find someone whose strategies align with your goals, seek their advice in making decisions. At the very least, it can be helpful to talk through ideas to see whether you’re on the right track.
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Updated for tax year 2020
Updated for tax year 2019