HIERARCHY OF SAVINGS

A system that first takes care of fundamental concerns and only then moves to higher levels, can ensure disciplined investing

You’ll probably be familiar with Maslow’s Hierarchy of Needs, if you've studied psychology, or more likely, marketing as part of your business school curricula. This hierarchy was formulated by Abraham Maslow to classify and understand levels of needs that human beings have. Starting from the most basic level, these roughly correspond to physiological needs, safety, social needs and, at the top of the hierarchy, what he called, self-actualization. According to Maslow, needs at a higher level become important only when those at the lower level are met. Someone who does not have enough to eat or whose basic physical safety is not assured is unlikely to worry too much about the deeper meaning of his or her life.

It is interesting to see that this idea of hierarchy of needs can be useful in planning one’s savings and investments. There are types of investments that belong at a higher level of a ‘Hierarchy of Savings’ and shouldn't be attempted before the lower levels are taken care of.

Here’s what I think this ‘Hierarchy of Savings’ should be like.

Level 1: Basic contingency funds: This should be the money that you may need to handle a personal emergency. Should be available instantly, partly as physical cash and partly as funds that can be immediately withdrawn from a bank.

Level 2: Term Insurance: A realistic amount that should be calculated to allow your dependents to finance at least short- and medium-term life goals if you were to drop dead is struck with a debilitating injury or disease.

Level 3: Savings for Foreseeable Short-Term Goals: Money that is needed for expenses that are planned to be made 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 other levels beyond this and really, the details matter much less than the concept. Also, depending on one’s circumstances, any of the levels may have to be modified. However, this is not an asset allocation tool. The point of this exercise is to prevent yourself from going to higher level unless the lower one is fulfilled. It’s simply a way of reinforcing that there’s little point in trying to fine-tune how much you will earn in an equity investment if you haven’t put away cash for an immediate emergency or adequate term insurance cover.