“Happiness is reality less expectations. When you control your budget you control your expectations.” – Vitaliy Katsenel
Happy New Year everyone! As is common around this time of year, many people are making resolutions to better themselves in some form or fashion. The most popular resolutions people make here in the US center around health and money (I’ll let you guess which of these two we are going to write about today). Over the years we’ve written a number of posts about personal finance including several on the importance of building financial freedom through budgeting. In today’s post, we’ll take a new look at the timely and important topic of budgeting for a secure retirement.
To many, the idea of budgeting sounds about as fun as dieting, but we would argue that is far too near-sided of a view. Yes, living within a budget means saying no purchases you might otherwise make, but the goal of a budget is take control of how your money is being spent. When you change your spending habits from being compulsive to intentional, you feel a tremendous amount of empowerment and freedom. Quoting one of our previous Insights on this topic…
Simply put, knowledge is power, and those of us who budget know more about where our money is going than those of us who don’t. This leads to more control, less waste and an increase in financial freedom. That’s right…while many would consider a budget to be restrictive, it is actually quite freeing because it takes the guesswork out of spending decisions and provides a foundation for systematically building out savings and investments.
Put another way, the discipline of budgeting creates clearer vision, and clearer vision leads to proper action… Purchases, both large and small, move from being haphazard and compulsive to fitting within a clearly defined plan. Spending, as a result, becomes more intentional and (ironically) more enjoyable.
Unfortunately, even those who buy what we are selling and decide to implement a budget, are still at risk of eventually giving up on it due to one big problem…unforeseen expenses. It is not uncommon for us to have some version of the following conversation with our clients and friends:
Friend: So what’s the number one thing I should be doing to make sure I can retire someday?
Us: Be more intentional about your spending and subsequent savings by implementing a budget.
Friend: Oh (somewhat disappointed in the answer), I tried budgeting in the past but it just doesn’t really work for me.
Us: Oh yeah, why is that?
Friend: Well it was great at first but then [fill in the blank unforeseen expense] popped up and totally blew up my budget so I just stopped doing it altogether.
Unforeseen expenses (e.g. medical bills, car repairs, etc.) are not fun and are unfortunately a fact of life, but they don’t have to totally derail our finances. In corporate finance, the most common way to account for unforeseen or “lumpy” expenses is by incorporating a sinking fund into the budget. A perfect example is the transportation industry. Companies in this industry typically own a fleet of transportation related assets such as airplanes, cars, trucks, and ships, which require repairs and maintenance in lumpy intervals. In order to properly account for these expenses, the company sets up a sinking fund where money is set aside on a regular basis (daily, weekly, monthly, etc.) to cover these somewhat irregular/lumpy expenses.
The same strategy can be applied to our personal budgets to cover less frequent expenses such as car repairs, a new car purchase, medical expenses, and the like. For example, let’s say you just bought a $20,000 car and plan on driving it for the next 5 years at which point it can reasonably be sold for $10,000. In order to buy another $20,000 car, you would need to save $10,000 over the next 5 years or $166.67/month in order to purchase the car outright with the value you received from selling your old car. Additionally, you know that there will be repairs and maintenance on your current car, so you do some internet research and figure out you should be setting aside another $100/month for these unknown future expenses. Then you top it off by adding in the more regular auto related expenses such as gas, taxes, insurance, and registration to arrive at a closer reflection of the true cost of owning a vehicle.
Setting up a budget that pays yourself first and sufficiently anticipates the true expenses you will incur in a given year is an excellent recipe for long-term financial success. Once you understand the true cost of everything in your life, you will be better equipped to make the necessary trade-off decisions in order to live within a budget and meet your savings goals. Would I rather spend my money on a fancy new car or take the family on a vacation? Would I rather eat out 5 nights a week or buy a ski pass? Do I want a bigger house with a bigger mortgage or spend more money on my health (e.g. gym membership, higher quality groceries, massage, etc.)? These are the types of trade-off questions that create a sense of empowerment and freedom because you have made the conscious decision that XYZ is more important to you than ABC, so you no longer feel guilty intentionally spending your money.
The fact of the matter is that, if left unchecked, our wants and desires will always exceed our income no matter how much money we make. Again pulling from a previous Insight which we like to repost around Christmas time every year entitled Burning a Hole in our Pockets, the following quote was from professor Michael Norton at Harvard Business School based on a study he had conducted.
No matter how much money you have, you think three times as much is the right amount. It just shows that we never learn. We always keep thinking that it’s the next level that is going to make us happy. It’s disturbing because if you look at the data, with two to three times as much money, you’re not that much happier.
So if more money doesn’t make us happier what does? We like the simplified equation from the opening quote which states that happiness = reality – expectations. Too many people spend all their time trying to improve their “reality” by making more money but they end up increasing their expectations and expenses in-line with or in even in excess of their new income reality. As an alternative or even a compliment to this strategy, consider a well-crafted budget that sets aside savings and accounts for extra expenses with sinking funds to control your expenses/expectations and maximize happiness.
Elliott Orsillo, CFA, is CEO and Founder of Colorado-based Season Investments. The company was created to provide high-touch financial services and an accessible investment alternative to the traditional “buy-and-hold” approach to investing. Learn more at http://www.seasoninvestments.com/.