Budgeting Can Make You Rich, But Can It Make You A Better Person?
Last week, Alejandro offered up an excellent blog post on advanced budgeting techniques. While these are extremely useful for those of us who already have a consistent budget, they take some work, and aren’t for the faint of heart. This week we think it would be useful to offer some more basic advice for people just getting started with budgeting, or who have been frustrated by it in the past.
There aren’t a ton of us out there who enjoy running through our personal finances every day, cross cutting them into different sections, and going through all the work required to keep everything straight. Whether you’re a budget newbie or a whiz, this week’s post has what you’re looking for!
The first question you might ask yourself is why you even need to budget or why you would want to budget. For some people, it is simply about making sure they don’t spend more than they earn, but for me, it goes much deeper than that. I see the budget as a tool that enables you to find places where your spending habits are misaligned with your personal values. You may think of yourself as a frugal person, or you may want to live more purposefully than you do now, but however you see your relationship with money and the role it plays in your life, budgeting can help bridge the divide between perception and reality.
Now budgeting looks different for everyone, so there isn’t exactly a one size fits all solution to preach. But there are some universal questions we all need to ask ourselves before embarking on a budgeting journey. Your answers to the questions below will guide how you think about your own budget.
What do I purchase that I can live without?
The purpose of this question is to separate discretionary spending from necessary spending. Housing and food for most people would fall into the necessary category. But think more broadly than that. Are you buying everything at Whole Foods and living in a McMansion? Perhaps your housing and food are more discretionary than you think.
At Monte Largo, we firmly believe there is no difference between a want and a need, and while I live in a modest single family home, I keep a strict food budget under $5 a day (for real). I understand people who live in tiny apartments but buy a latte every day. While we all make different choices, and none of those choices are inherently bad, it is important to recognize that everything we do outside of basic survival is optional, and that a single family home, like a latte, is a choice.
How do I want to separate my expenses?
This is a tricky one, namely because “food” or “entertainment” can take so many forms. Are restaurants and groceries lumped together or separated out? Is bar hopping with friends the same as visiting a national park? Do plane tickets get placed with gas you buy for your car in a transport category? There are dozens of budgeting products on the market, each of which claims to have a new and better way to dissect your expenses for you.
At Monte Largo, we’d certainly tell you that restaurants and groceries are not the same (a restaurant is not an acceptable way to get food, merely entertainment), but we might separate an activity that brings health (like biking through a national park) from bar hopping. Then again, we might not. Budgeting is an extremely personal activity, and you should think about your lifestyle before adopting someone else’s budgeting scheme.
How much of my money do I invest?
This, in my opinion, is the trickiest question to answer. It is easy to say “My bike is an investment because it keeps me from spending money on my car when I bike to work” and it is also easy to say “My bike is an expense because I only ride it casually on the weekends, or it just sits in my garage.” The same rule applies to housing and pretty much every kind of investment that does not produce cold, hard cash for you with minimal effort.
While not every budget needs to be separated into expenses vs. investments, it can be a handy tool when calculating your savings rate. Just because you spend money on something doesn’t automatically mean you are taking money away from your savings rate, especially if you’re throwing it into a real investment.
Ultimately, asking yourself the above three questions and developing a budget has a practical purpose besides understanding where your spending may be misaligned with your values. It shows you your savings rate — the most important indicator of your financial health. If you plug your savings rate into a retirement calculator, you can estimate when you will become financially independent (FI). It enables you to see your current financial situation as clearly as possible in concrete and understandable terms.
Not every budget can yield this level of insight, so how do you ensure that yours will?
The Monte Largo Way
How do we advise clients to budget? When you become a client we’ll ask you to separate your expenses into four categories: Perfect Recurring, Non-Perfect Essential Recurring, Non-Perfect Non-Essential Recurring, and One-Off Expenses. The chart below shows what that looks like.
Effectively all we’re trying to do is see how much you know you are going to spend every month (Perfect Recurring), how much you can estimate you’ll spend beyond that (Non-Perfect Essential Recurring), where we’ll first look to cut things (Non-Perfect Non-Essential Recurring), and anything extraordinary that might throw your budget off in any one month (One-Off). The transparent areas (which is a huge percentage of expenses) are areas that can often be minimized or mitigated against…that’s what the financial plan is for. See the second page of our Client Information Sheet for more detail.
Obviously this system, like any system, isn’t perfect. Some expenses are still hard to categorize, and four big buckets hardly give us the detail we need to dive into certain expense types. Budgeting is always a highly personal process, so we draw up financial documents for our clients that show their spending through a variety of lenses.
What kind of budgeting systems have you found useful? Tell us in the comments below.
Nathan is the CEO of Monte Largo Financial Advisors LLC.