If you have ever taken a psychology 101 class, you probably encountered the timeless classic Maslow’s Hierarchy of Needs. Most commonly presented in pyramid form like you see below, the hierarchy provides a breakdown of a person’s needs, with the needs at the bottom of the pyramid being the most basic prerequisites for moving on to the next levels of the pyramid, until ultimately all basic needs are met and a person can attain the state at the top of the pyramid called “self-actualization.”
In a world where the everyday person lives with a multitude of basic financial needs they must take care of before they can move on to achieve their “financial self-actualization” – the things they really want to do with their money – I’m surprised I’ve never seen something like Maslow’s hierarchy to help people clearly organize their financial needs.
As I have not seen something like this I suppose I get naming rights – so I hereby present to you “Ruedi’s Hierarchy of Financial Needs.”
The Base of the Pyramid: The Emergency Fund
Let’s start, as Maslow does, with the most basic need at the bottom of the pyramid – the base layer on top of which all subsequent layers are built. This first layer is the establishment of an emergency fund. The textbook recommendation for an emergency fund is anywhere from 3-6 months of non-discretionary expenses, that is, expenses you cannot do without such as rent, food & water, medications, etc.
Having this fund makes sure that any little financial bumps in the road (sudden health costs, loss of a job, uninsured property loss) don’t completely knock over your financial pyramid.
But of course every situation is different, so make sure you consider all your needs and your unique situation. If you have a high deductible health plan, for example, you may want to have at least the deductible amount sitting in cash.
Level Two: Insurance
With an emergency fund ensuring no sudden expense can sink your financial future, you are free to move on to the next need. This for many people is purchasing insurance to “ensure” that their family’s financial future will not be derailed by the loss of that person and their income. If you are young, single, nobody depending on you – feel free to skip to the next step.
For the rest of you, making sure you have adequate insurance is a prerequisite for moving up the pyramid – why even take steps to save if your financial plans will be completely derailed by the loss of you, the saver?
Level Three: Pay off High-Interest Rate Debt
With insurance in place, so the financial pyramid doesn’t topple over if something happens to you, you can happily move on to the next step of the pyramid – paying off high-interest rate debt. When I say high-interest rate debt, I don’t mean to rush to pay off your mortgage debt that accrues interest at 3.5% – I mean the thousands of dollars of credit card debt – the type with interest rates that make it really hard to chip away at that balance.
You are probably better off paying off your high-interest rate debt before you move on to saving and investing. For example, if the expected return on a portfolio you invest in is 10%, and the interest rate you are paying on your debt is 13%, by saving/investing instead of just paying off your debt you are accumulating debt faster than you are growing your assets, digging yourself further and further into a hole even though you are technically “saving”.
So before you even start saving, make sure there is no potential for the creation of a bottomless pit of debt that you will eventually have to rob your savings to pay off.
Level Four: Saving and Investing
Without high-interest rate debt to pay off, a person can finally move on to saving and investing – and this is where it starts to get fun because you are starting to save to fund your needs and eventually many of those self-actualization goals. There are many rules of thumb about how much a person should save – but rules of thumb shouldn’t be called rules at all since most of them don’t really apply to the vast majority of people. The amount a person should save should depend on their goals – many people need the help of a financial advisor to determine just how much to save to fund those goals.
The Top of the Pyramid: Financial Self-Actualization
With all your most basic financial needs taken care of and your goals funded by a savings plan, you are finally at the top of the pyramid – your financial self-actualization. What exactly does financial self-actualization mean? I suppose the best answer would be a state of being where you are able to use your money for the things that truly reflect your values and make you happy.
That means so many things to so many different people that I won’t even bother to write about it but rather will defer to you the reader – so think about what these financial self-actualization goals are for you. No matter where you are on the pyramid, keep these goals in mind as motivation to move forward through the entire hierarchy.
Though they may seem far out of reach right now, if you get your priorities straight and make the right financial moves while you climb up the pyramid, anything is possible!