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 human needs.
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-actualisation. According to Maslow, needs at a higher level become important only when those at the lower level are met. A hungry person is unlikely to worry much about the deeper meaning of life.
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 immediately accessible bank balance.
Level 2 Term Insurance: A realistic amount should be calculated to allow your dependents to finance at least short- and medium-term life goals if you were to drop dead or incapacitated.
Level 3 Savings for Foreseeable Short-Term Goals: Money needed for expenses you plan to make within 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 levels beyond this; the details matter much less than the concept. Depending on one’s circumstances, 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.