Why a budget is a waste of time. And what to do about it!
Have you ever created a budget? Ever failed to keep to your budget after only a little while? Its been time honored advice of almost every personal finance blog and investing book ever since Adam was a boy. Create a budget a stick to it. Work out your income and expenses and then, happy days, you’ll be on your way to F.I.R.E. BUT budgeting is a waste of time. In this article, we set out why a budget will fail and how the Smith family keeps savings high and deals with lumpy income and expenses.
Why a budget is a waste of time
In a former life, I was in charge of the budget at a very large financial service company. For a few months every year, thousands of man hours were spent analyzing data, forecasting outcomes, crunching numbers and bringing it together in a nice PowerPoint for the board to review. The rest of the year was then spent comparing the actual results to the budgets, tweaking the results and explaining why sales were down or expenses were up. It was a huge process, but kept the companies finances on track. We knew where we were going (mostly) before we got there. The key was that there was always someone looking over your shoulder. Be it the Board over the CEO’s or the CEO’s over his divisional managers, variances to budget had to be explained and reported. Hence it controlled the companies financial results.
Budgets are a financial control tool and a control tool is only ever as good as the ability of users to stick to it. Usually, that’s an external influence. Your boss leaning over your shoulder wanting to know why costs are up is a great incentive to keep them under control. Who performs that role in your personal budgeting process? For most people, its going to have to be themselves and that’s why you’ll fail.
I don’t know about you, but I don’t have the greatest self control in the world. The temptation to “cheat” is too great – especially when no one else knows that you cheated. Some people may be great at self control, but it takes energy – especially at first.
Budgets and behavioral finance
Ah Ha! you’re thinking. I’m better than that. I have great self control.
The biggest breakthrough in finance in the past 20 years is the development of behavioral finance. That is, the way humans act is different to the way classical finance theory says we should. We each have personal bias that drive the way we act and perceive the world (funnily enough, we’re not all rational investors)!
One of the top 10 behavioral bias is overconfidence and illusion on control. Its an egotistical belief that we are actually better than we are. Its not a bad thing – its just how we’re built. That extends to our belief in how well we can build a realistic budget and then stick to it. The reason it works for companies is that there are lots of people challenging the numbers. The reason it won’t work for you is that there is no one (properly) challenging.
If budgetting is a waste of time, what the hell do I do?
First – don’t despair. There is a good and potentially easier answer than creating a budget. There are many variations on a theme for this process, but essentially it boils down to “pay yourself first”. It’s a process that’s been extensively written about, but it works!
Huh? WTF does “pay yourself first” mean?
It means that you save before you spend. By saving first, then spending second, you have locked away savings – effectively making savings “auto-pilot”.
If we look at behavioural finance research, we know that humans tend to take the path of least resistance. Its just easier. By saving first, it takes the decision of how much to spend each month out of your hands. Budgetting fails because even the best of us “cheat” from time to time when we know no one is looking (its one of the reasons I put my financial data up, people are looking and I feel guilty spending more than I should if I know that).
So how does the Smith Family do it?
As salary and wage earners, our income is pretty consistent from month to month, which makes paying yourself first easier. We don’t bother creating a budget, as we’ve proved time and again that we can’t keep it up. We detail this in our monthly net wealth reports. Our fortnightly income after taxes and superannuation contributions is $5,850.
From this, we firstly worked out how much we could save from this. The rule of thumb 20% of income seems a bit high in the Australian context, because of our compulsory superannuation system, so I aim closer to 10% of our after tax salary. That means each fortnight we have about $500 in cash to invest. We also don’t include the amortization part of our mortgage to be savings (that’s the bit that is reducing the principal on the home loan). While its increasing our networth, its again “hidden savings”.
In Australia, we have a compulsory form of retirement savings called Superannuation. 9.5% of every workers salary automatically goes into a retirement savings account and can only be accessed once you reach 65. I don’t consider this forced savings as part of our income as we never see it. It’s effectively hidden savings.
Once we’ve taken out our fortnightly savings of $500, the rest is for bills and expenses, including mortgage payment. That’s what we live off.
Help! What do I do if I don’t have consistent income?
This is a bit harder, but not an impossible situation. You either need to smooth your expenses or your income. We use a combination of both. Again, its easier to automate this process and keep human decision making as far away from it as possible. Using separate bank accounts and automating expenses are both great tools in this regard.
How the Smith family deal with inconsistent income and expenses
I get paid a bonus every year that is about 30% of my income for the year, which adds a fair bit of lumpiness to our cashflow inflows. We also get large, lump sums from time to time such as redundancy payments. Mrs Smith also works on a part time basis, so her income goes up and down depending on how much works comes in.
In both these cases, the trick is forward planning. We usually know several weeks in advance how much the bonus payment is going to be. Mrs Smith and I sit down and discuss how and where we want to deploy it once it comes in. This is usually a tussle between big spending items (e.g. upgrading our fridge) and paying down the mortgage. Once the cash comes in, we automatically move it to other accounts according to The Plan. If we don’t intend to deploy it within a few days, it gets put into a savings account or CD until its needed. We use a different bank for these, so that the cash is harder to get to!
For variable spending, we use a similar approach to lumpy income. Because we have significant spending history, we know pretty well what our lumpy expenses are going to be and when they are due. From there, we have calculated that we need to put aside $280 per fortnight to cover these lumpy bills. We do this by automatically putting the cash into our Paypal account and paying the bills out of there.