Tuesday, 15 October 2013

What should I do with my bonus?

People in many industries (including finance) get paid on a salary + bonus structure every year.  However because of what it is called, even if a bonus is relatively certain and you know the approximate amount you are going to receive, people still treat it as a windfall rather than as an ordinary part of their income.  I would argue that you should plan to spend and invest your bonus in much the same way you do your ordinary income - spend a part of it, save/invest a part of it and put some aside for a rainy day.

What is the problem with treating a bonus like a windfall

There are a couple of major problems with treating a bonus as a windfall which include

  • No one really plans for a windfall which means that most people, when they receive one tend to blow it or invest it haphazardly.  Just think about what you have ever done if you have one a cash prize or received a modest inheritance - most people do not do sensible things with it
  • Even if you do invest it...lump sum investing is always more risky.  There are others (and I fall into this category all to often) who treat the bonus like a windfall and know we should invest it but then go out and do it in one hit so we don't have piles of cash lying around.  The big problem in this is that we may not be doing this when we have a great investment idea and if we stick it in something like index funds then you're effectively saying that this was a cheap point in the market
  • People rarely stick some aside for a rainy day.  I have never been a 'rainy day stash' kind of person however I've realised that having a small amount of cash that doesn't get touched except in extreme emergencies is a valuable thing.  Putting aside a very small amount of income every month can help you build up this slowly and bonuses (where you have excess uninvested capital) offers an opportunity to top this up
How do you plan for a bonus?

The simplest answer is to plan to spend and invest your bonus like any other budget.  However you need to put less into personal expenditure as your regular income normally covers this and more to saving and investment.  Here are some steps which means that you wont be scratching your head when you actually receive it:
  1. Estimate the amount you are going to receive
    • I know that the amount most people receive is uncertain and in some cases people are expecting a large bonus and a much smaller one comes ( I have rarely seen the opposite)
    • However most of the time our expectations have been managed to a certain range so plan on the low point of that range
  2. Allocate the amounts to saving / spending and investing
    • I know I said above that you should allocate a lower percentage to personal expenditure however this does not mean that you shouldn't spend anything on yourself...that takes all the fun out of getting a bonus (and life)!
    • The bulk should be saved in cash or invested
  3. For the cash component - stick this in a high interest saver or term deposit straight away
    • I tend to use high interest saver accounts because term deposit terms and rollovers are a pain in the backside although they do offer the greatest return - this is just me being lazy - if you have a significant amount in cash you definitely want to look into term deposit rates
  4. For the investment component think about whether you have a definite investment idea or not
    • At the moment I don't have any big 'winning' investment ideas so the chances are that I'm going to put it into index funds
    • As I'm putting it into index funds I want to spread my entry points as there is no point effectively timing the market by putting it all in when I get it
    • Putting it in over 2 or 3 months allows you to spread your bets somewhat
  5. Set your plan before you receive your bonus and then FOLLOW your plan
    • For some people there is a gap between when they get told how much they are receiving and when they actually get the cash - this is the time to set your plan - to work out (before you have the money) what are you are going to do with it
    • The key is then to follow exactly what you said you were going to do - chances are this is when you're making a well thought out decision
Do you do anything different when you receive a bonus?  I would love to hear about it!

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