Hierarchy of Investment Needs
Let’s play a quick game. Let’s say that you only had $1,000 dollars, and you had to rank the following financial needs in order of importance. How would you rank them?
A family vacation to Hawaii.
Your son’s club soccer fee.
Food for your family to survive.
If you had to rank them in the order of importance, like most people, you would rank food and water the most important, your son’s club soccer fee second, and a family vacation to Hawaii last. Or I hope so.
The reason many of us would rank in this order is that even though we know paying for our son’s after-school fee is important, we know that food comes first for our family’s survival. And definitely more important than a vacation trip to Hawaii.
As humans, we have basic needs and wants. And there is a general unspoken order or priority that guides our decision-making. You’ve probably heard of one of its more famous ones, the “Maslow’s Hierarchy of Needs.”
Psychologist Abraham Maslow believed that every single individual has a hierarchy of needs that broadly cuts across five tiers: physiological needs, safety needs, love and belongingness needs, esteem needs, and self-actualization needs. This is usually depicted in hierarchical levels on a pyramid starting from physiological needs on the bottom and then to the self-actualization needs at the top.
The general idea of this framework is that higher needs will only begin to emerge when we as humans believe we have sufficiently satisfied our more important needs. In other words, it is only after we have eaten that we can decide whether we want to vacation in Hawaii or not. This theory guides different aspects of our lives as humans, and we can also apply it to the world of investment as well. Investments are made for a wide range of needs:
One could be saving for one’s retirement, which can be many decades away.
Another could be saving to buy a house in 5 to 10 years.
Or one could be saving for a new laptop which could be a couple of months away.
So in this post, we are going to review the five levels of the “Hierarchy of Investment Needs” so you can use it as a framework to help you prioritize your money based on the stage of life you find yourself in. I’ll also cover for some of the levels the best location to store your money, so you are minimizing risk while maximizing returns.
01 - Basic Financial Needs
Before we can even think about other investment needs, we want to invest in resources to cover the basics to sustain ourselves and our family, basics like food, water, clothing, transportation, and shelter.
We cannot jump the gun when it comes to crafting our investment goals. In Maslow’s hierarchy of needs, physical needs come before relational needs, and relational needs come before self-actualization.
In the same way, we want to focus on having consistent income or savings to be able to afford food and shelter before planning for a vacation or shopping for new clothes. And even before shopping for a brand new house or even our retirement. Practical steps we can take to be able to meet our basic financial needs include first developing a solid career capital.
Career Capital
Cal Newport, the author of So Good They Can’t Ignore You defines career capital as the following:
“The skills you have that are both rare and valuable and that can be used as leverage in defining your career'. - Cal Newport
When we talk about growing our net worth, it's important to talk about budgeting and investing, but the key fuel to start all that begins with income. If you have a low income, it's really hard to move up the hierarchy of investment needs. Towards your other financial goals and growing your investment.
You can only cut so much from your budget. And if you don’t have a decent amount of capital, you can invest in the market, it doesn’t matter how much returns you get on your investment, a 100% return on 10 dollars will only be 10 dollars.
Therefore you want to have a solid income, and that starts with solid career capital. Something that you can offer to the market in return for a high income and salary.
Budgeting
Once we have a healthy, consistent income, we want to learn the basics of budgeting, so we learn the crucial skill of managing our expenses. Operating household finance without a budget is like having a big hole in your purse or wallet. You will always wonder where your money went.
Emergency Fund
I would also include having a healthy level of emergency fund at this level as well. Emergency funds are there for unplanned and unexpected life events. Losing your job, a car repair, or a medical emergency.
Without it, our grandiose plans to save for future goals or invest will always get derailed. Something will always come up that will require us to funnel money from other areas of our budget. Or worse yet, we can even go into credit card debt because we don’t have the financial cushion.
If you don’t have one, I strongly urge you to build up at least 3 to 6 months of expenses. If you are more conservative like my wife and me, I would even recommend 12 months of expense.
The best place to park money to meet your basic financial needs, as well as an emergency fund, is a simple checking account or a savings account. The key word here is liquid. You want to be able to easily and quickly access this money without any penalties. Earning interest is not a priority here. Having it accessible is.
Hopefully, we don’t stay at this level too long, but if we are currently here, know that you are building a solid base foundation for the next levels in your hierarchy of investment needs.
02 - Insurance
Once your basic financial needs are met, meaning you have enough cash flow to take care of your family, good expense management habits, and you have a well-funded emergency fund to handle life’s emergencies, we want to start looking at protecting ourselves through good insurance. I believe the four must-have insurances that we can’t live without are the following:
Homeowner Insurance
Auto insurance
Health Insurance
Term Life Insurance
Now why is insurance important, and why do I think they belong in the hierarchy of investment needs? When you look at world champion-level sports teams, it isn’t just their offense that wins the game. World champion teams have a strong defense in addition to a strong offense.
Just look at soccer. What’s the point if your star striker scores six goals when your weak defense just gave away 7 points? Your team lost because you were only focused on scoring and not defending your goal. Think of spending money on good insurance as an investment in a strong defense.
A study published in the American Journal of Public Health found that 66.5% of bankruptcies in the US are due to medical issues. Serious diseases or injuries easily result in hundreds of thousands of dollars in medical bills.
When we don’t invest in adequate insurance like health insurance, these bills can easily wipe out savings and retirement accounts, college education funds, and home equity. Also, imagine if you didn’t invest in quality homeowner insurance before a natural disaster wiped out your home.
According to a study released by CoreLogic, a property research organization, in 2021, about 1 in 10 homes were impacted by natural disasters—over 14.5 million homes, totaling nearly $57 billion in property damage.
If we don’t invest in good insurance to protect us, all our hard work towards building our financial wealth can easily be wiped out with a single health issue or a single wildfire. The bottom line is that while good financial habits like budgeting, saving, and investing will grow our wealth, investing in insurance will protect our wealth.
03 - Short-Term Investment Goals
Short-term goals are those goals that we want to be able to meet between just a few months to less than 36 months or three years.
Think of saving up for a vacation, planning for holiday gifts, or that new dishwasher that you’ve been eyeing. Or it could even be paying off high-interest debt like student loans. Items you can start thinking about after your basic financial needs are met, and you have adequate insurance to protect your family.
Because this is a short time frame, you should keep the money for this type of investment where there is very minimal risk, and it is easy to liquidate. My recommendation would be a simple savings account. Most often, they have no restriction to when and how much you can pull, and they are easily accessible similar to a checking account.
You might be saying, but Tae, how about the interest rate? Wouldn’t it be a shame to have my $1,000 dishwasher fund just sitting in a savings account, losing value when I won’t be using it for a year? Well, normally I would say that is the cost of keeping your money liquid and safe for your short-term goals. However, we are at an interesting time now.
For the past decade, it was almost impossible to earn more than 0.01% interest on your cash, given how low the interest rates were. However, because we are at a time of high-interest rates, there are places where your cash can earn a higher interest rate.
Most banks have been slow to raise rates on standard savings accounts, but the general rule of thumb is that Fed rate increases should lead to higher returns on savings. If you shop around, there are currently high-yield options available. Start with your current bank, and make sure to ask around.
If you are willing to move your money because you aren’t too tied to your current bank, banks like Capital One and Goldman Sachs’s Marcus are offering 3.0% in annual percentage yield. A year ago, you would have been hard-pressed to find an account with even one-tenth that in interest.
The bottom line is once your basic financial needs are met, and you are adequately covered with good insurance, you will start to feel more comfortable investing to reach your short-term goals.
04 - Medium-Term Investment Goals
Medium-term investment goals are goals that are greater than 3 years but less than 10. Some common goals are saving up for a house downpayment, kids’ college tuition fund, or a new car. Think of large purchases that come around once every 5 to 10 years or so.
To be honest, this is probably one of the hardest levels to save for. It's a weird in-between place. Goals that aren’t decades away, like retirement, but also aren’t coming up within this year. The amount is large enough to make you feel a bit uncomfortable holding it in your checking and savings account, but you also feel a bit scared about putting it in the market, given all the volatility.
And there is a lot of debate as to where the best place to park your money for these medium-term investment goals is. Let me share with you a few popular ones so you can make your own decision.
Savings Account
I know a lot of people push back on this, but savings accounts shouldn’t be overlooked as a viable option, especially if you need a specific dollar amount by a specific date to achieve your goal. As I mentioned earlier, there are now savings accounts with decent interest rates. So if you can find one and you are really risk averse because you don’t want to risk losing your home down payment, a simple savings account is probably the safest place.
Certificate Of Deposit
CDs often provide a slightly higher interest rate than savings accounts, but there are two potential downsides to consider. The first is the fact that you might be penalized if you withdraw the money early. The second is that if interest rates continue to rise, it may not be long before you’re able to get a better interest rate with a savings account than from whichever CD you buy today. But if you played it right, you could get a better return than a simple savings account. And the money is also well protected - no chance of it losing value like an investment. If these sound appealing to you, a certificate of deposit could be a good option.
Index Fund
The third option is to invest in a low-cost broad market index fund in a regular taxable account. To be honest, this feels risky to me. Unless you know you are saving and investing for a goal that is at least ten years out, this is the riskiest option when it comes to a medium-term investment goal. It is very important to understand that risk, and returns go hand in hand when it comes to the stock market. The higher the expected return, the higher the expected risk. So make sure to consider that in your decision-making.
I know there are tons of other different options out there that I haven’t covered, so do your research for these medium-term investment goals. I know a popular one recently was the I-bond, a US savings bond designed to protect the value of cash from inflation.
So much of what makes sense for you depends on the specific goal and the time frame, but I’m sure the financial industry has no shortage of products designed for all specific needs. Just make sure to do your homework and balance risk versus reward, as well as your time.
05 - Long-Term Investment Goals
Last on the hierarchy are your long-term investment goals that are over ten years. These investment goals are usually tied to preparing for financial independence or retirement.
And this is where we can invest in the volatile stock market because we have confidence that over a long period, US companies and the market will appreciate.
The reason this comes last is that, most often, we cannot successfully plan for retirement if we haven’t successfully taken care of our basic financial and insurance needs. It’s hard to think of the kind of house we will want to retire in until we have successfully taken care of the house we are living in now.
The best type of investment to meet this long-term retirement goal is broad market low-cost index funds. Some of my favorites include the following:
All these funds are variations of the total market or the S&P 500 index and all excellent equity funds to hold as your core wealth-building tool.
In summary, an excellent way to look at the hierarchy of investment goals is in terms of risk. In the short term, you want to take a very little risk because you need your money to retain its purchasing power as well as be accessible.
However, as you move up the hierarchy of investment needs, you can take risks based on your risk appetite. Use this as a tool and a framework to guide how we deploy and invest our money in relation to our needs.