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Thursday, May 28, 2009

Budgeting: Part 3: All About Choices

"Your life is the sum result of all the choices you make, both consciously and unconsciously. If you can control the process of choosing, you can take control of all aspects of your life. You can find the freedom that comes from being in charge of yourself."

- Robert F. Bennett


[ I'm picking up right where I left off after a year of various time-consuming issues. I have many new things I'd like to write about, but I believe in finishing what I start, so I'll be continuing this budgeting series for now. It's probably a lot more appropriate for many people now than it was a year ago. I know it is for me! ]


Every single day of our lives we are faced with a barrage of spending decisions. Sometimes it can be almost overwhelming. Are we in control of our spending? Or is our spending in control of us? Even those of us who don't feel like we are "out of control" nonetheless often feel like our spending decisions are not always explainable. Why do we say "yes" to certain purchases one month and then "no" to the same purchases the next month? Why do our choices on some occasions seem almost arbitrary?

A large part of the confusion about spending is that purchase decisions are usually framed in isolation. For example, the following three purchases could be framed as simple yes/no decisions:

  • "Should I purchase this new car or not?"
  • "Should we eat out tonight or not?"
  • "Should I replace my air conditioner or not?"

A small step up from yes/no framing are the sorts of questions that are framed as "Can I do better?" Thus, the previous examples could perhaps be reframed as:

  • "Is this the best price I can find on this new car?"
  • "Do we have a coupon for this restaurant?"
  • "Will the air conditioner be on sale later this year?"

Another typical framing is some variation of "Is it worth it?" For example:

  • "Is this car really worth $18,000 to me?"
  • "Do we really enjoy eating out that much to spend $40 on dinner?"
  • "Am I prepared to spend $2000 to have the house be cool this summer?"

Yet another framing is some variation of "What are my other options?" In other words:

  • "Would I be better off with a $6,000 used car or a $18,000 new car?"
  • "How about ordering takeout for $30 to avoid charges for drinks and tips?"
  • "Could I get by with a couple of $200 room air conditioners?"

There is nothing wrong with the how any of the questions above are framed. Even a simple framing of a purchase decision will help you avoid stupid mistakes. It's a good thing to eliminate purchases that you haven't properly considered (i.e. "Should I buy this?") or that you don't really value for the money (i.e. "Is it worth it?"). And it's always good to find the best price (i.e. "Can I do better?") and consider your other options. But let's face it: even after you've done all that, there will still be millions of things in the world that you consciously value and are reasonably priced - far too many things than you could ever really purchase in your whole life!

It's a sad fact of life that many people really don't go beyond the above approaches with their decision making process. Instead, having only muddled through each purchase in isolation and having found that there are lots of cool things in the world to be had, people often continue to purchase things with this framework until a certain trigger is reached. Now where exactly the trigger is reached depends on attitudes toward savings and debt. For some people, the purchases continue until the checking account is zero. For others, the purchases continue until the credit cards are all maxed out. For still others, the purchases continue until 3/4 of their income is spent, at which point the remaining 1/4 of their income is saved. So please note that a simplistic approach to purchases does not always imply debt. Such a paradigm is not necessarily irresponsible. On the contrary, a lot of reasonably frugal people operate with a simple framework and manage to save a substantial amount of money. As I said earlier, the trigger point to stop spending is determined by preconceived ideas about savings and debt, which vary wildly from person to person.

However, regardless of the differing trigger points to stop spending, there is something badly broken about this sort of process. Each individual purchase may be reasonably well considered, but as a whole, I would argue that such an overall spending pattern is rather arbitrary due to the lack of a holistic approach.

So what do people lose with such an approach? Money? Probably not. What is lost - for lack of a better word - is happiness. If you are truly determined to save 10% of your income and you stop spending when that limit is reached, then it's not money that's at stake. One way or another, you will save 10%. But without proper context, the 90% of your income that was spent will not really be spent on the things that you value the most!

Think about how one arrives at the spending limit with such an arbitrary approach. You spend, spend, spend until the trigger is reached and then stop. Without a holistic approach, what determines which things were spent first and happened to arrive before the cutoff? Random chance? Advertisements? Other people? I certainly don't want those things to be the determining factors in what I buy with my money.

That is where budgeting comes in. A good budget will be able to frame spending decisions in context and emphasize this critical point: Whatever you spend on one item leaves less to spend on all other items. This is the true insight of a properly constructed budget. Another powerful concept is to consider saving money as just another budget item. Saving (or borrowing!) is usually thought of merely as a by-product of your income and spending - it's simply the part of your income that is left over after all the spending is finished. However, since saving money (consumption deferral) is so critical, I would encourage people to view a "savings" line item as competing with all the other items. Thus, when you are creating a budget, you should weigh each new item not only against the other items, but also against your savings target. Here is the basic idea:

  • Make a list and rank order everything you want/need to purchase.
  • Work through the list in order. After each item, calculate the cumulative total of everything you've decided to purchase so far. Compare the total to your income and decide whether you are comfortable with the resulting saving (or borrowing) total.
  • Revisit the list whenever you consider a purchase of something not originally on the list, or whenever you want to revisit your savings rate.

Does our family really do this? Well...yes. But perhaps not as you might imagine. We certainly don't sit around with calculators to figure this out, and we certainly don't agonize over each item. We also know we haven't captured everything and we don't worry about it. We know we will have to adjust things as we go. However, the main idea is still very much there. When we decide to spend more money on something else, we know we've weighed that against the other items in the budget and against how much money we are saving, and we're at peace with the decision. We also do this exercise when truly unexpected items arise. So if the refrigerator fails, of course we don't sit around and do spreadsheet analysis while food spoils. We march down to Sears and buy a refrigerator. We intuitively know we value a working refrigerator more than most items, so we know we should buy it. However, we're also aware that buying a bottom-of-the-line refrigerator will either bump other items in our budget or will change our savings goal. And we know that if we choose to buy a fancier refrigerator, we know exactly what we're trading off for that additional cost. We've already decided what's first in line to go!

I anticipate that there will be objections to this sort of process, so let's work through a few of the obvious ones:

  • "You don't understand. I already purchased a new car with credit and I'm still paying off the loan. I don't really value the car as much as I value other things I see right now, but I still have to make the payments on the car loan." Absolutely. Whether you value the car highly right now is basically irrelevant. You value your credit worthiness and perhaps you want to stay away from anything legally messy like a repossession. Hence, you value your commitment to your obligation to paying the car loan very highly, and so it's near the top of the list. Nothing about your situation contradicts the budgeting process I described.
  • "I have to eat. I need a place to live. I don't see how these sorts of things can be prioritized and placed in a list." Obviously one has to have basic needs met to live. Clearly you must have food to survive. Thus, "food" should be at the very top of the priorities list. But be careful: you must eat a reasonable quantity of something nutritious or you will die. On the other hand, a $5,000/month grocery or dining budget is clearly a luxury. Thus, you must break down the food budget into strata. You MUST eat something, so for example, you (probably) must budget $20/week for food. You cannot choose anything instead of this or you will die! But what about an additional $20/week? Getting by on $20/week for food is very tough, but it can be done! If things are very, very tight, then you have to make a choice between that additional $20/week or housing or clothes or other pressing items. If things are not tight for you, then first be thankful it is not, but also realize that your food bill can grow unchecked to $50, $100, or $200 or more per week. At some point, that incremental amount of money is not going to be worth it compared to what you could spend on other items, and that is exactly what this whole blog post is about: finding the right balance between all your spending items.
  • "There's absolutely no way I could compare every item I think about purchasing against all the other items! It would take half my waking hours and paralyze all my decisions if I really did that." The initial creation of your budget will absolutely take some solid hours of work. Assume that you'll have to spend a good chunk of one weekend and that you'll need to involve other people in your household if you want to do it correctly. But beyond that, the time involved is pretty minimal. Once things are all set up and ranked, it only takes a couple of minutes to handle a brand new spending decision, and if the purchase isn't that large, you can handle the adjustments after the fact. It's really not that difficult.

Go back and look at the quote at the top of this post. Don't dismiss it as flowery words! It's a powerful idea that can really apply to all aspects of your life. But since this blog is about finance, I will narrow down the scope and paraphrase the original quote: "In the realm of your personal finances, a budget is your tool to help you control the process of choosing the things you value most. And in that realm, if you can control the process of choosing, you can control all of your finances. You really can find the freedom that comes from being in charge of yourself."