Thursday, August 18, 2011

Budgeting: Part 27: The Long View

"If you feel demoralized and exhausted, it is best, for the sake of everyone, to withdraw and restore yourself. The point is to have a long-term perspective."

- Dalai Lama

If you feel that you need to make large budget adjustments, the first thing I would suggest is to step back from all the numbers and make an intuitive assessment about whether your goal is reasonable. I'm talking about a financial "gut check".

Is your desired lifestyle compatible with your earning potential? For example, if you imagine owning a large home, driving late-model cars, pursuing expensive hobbies, and traveling extensively, you better have an income that supports all that. Be sure to also factor in your existing debt situation and desired savings, because these are large cash drains.

If there is a big mismatch between lifestyle and income, you'll need to get that straightened out before worrying about a bunch of numbers and categories. Budget adjustments can only take you so far. If you have a big imbalance, you will need to accept a major lifestyle adjustment or career adjustment first.

It is probably useful to mentally conduct this evaluation every 5 years or so, just to make sure your career and lifestyle haven't drifted apart. Once your lifestyle is roughly in sync with your income, you can move on to the yearly budgeting process, which I will describe in my next post.

Wednesday, August 17, 2011

Budgeting: Part 26: How To Reduce Expenses

"Remember the two benefits of failure. First, if you do fail, you learn what doesn't work; and second, the failure gives you the opportunity to try a new approach."

- Roger Von Oech

Before we discuss realistic ways to cut your household budget, let's first start with how not to reduce expenses, as there are so many articles that recommend one of two unrealistic approaches: a) across the board cuts, or b) canned checklists of ways to save money.

There are several problems with across the board cuts and together these issues almost guarantee that the approach will not be successful.

1. Most people have a substantial number of large items which are contractual items that cannot be cut or eliminated in the short run. (e.g. rent, car payments, yearly phone contracts, school bills, etc)

2. Many expenses are fixed amounts that can't be cut by a certain percentage. You can watch 10% less TV, but you won't get 10% off your cable bill for doing that.

3. Certain items cannot be cut without costing you more money elsewhere in your budget. This includes maintaining your health and property.

Taken all together, it's clear that a large portion of your budget either can't be cut by a certain percentage or can't be cut at all in the short run. This means that if you hope to achieve a certain overall reduction in your budget, the cuts in the truly discretionary parts may need to be enormous. For example, if you want to reduce expenses by 20%, but two thirds of your budget can't be cut in this manner, then you will need a 60% reduction in the remaining third. Obviously such a large cut is unlikely to be successful.

Another complication is that we spend money on so many different things. Thus, the process of examining all these categories is not pleasant, and deciding how they will be cut is even more unpleasant. We also don't value all items equally, and so some automatic cuts may end up making you personally miserable even though they are financially small.

The checklist idea for reducing expenses is very common in the media. You've probably seen these types of articles: "10 Easy Ways To Save Over $20,000 Per Year" or "21 Simple Ways To Cut Your Personal Budget".

Most of these articles say it's easy to cut expenses only because they assume a very high degree of frivolous spending. Yes, it's very easy to cut expenses if you are currently buying a $5 latte every morning, eating dinner at a fancy restaurant seven nights a week, and grossly overpaying for all your insurance and utility costs.

The bottom line is that while both of these methods are not bad advice in theory, they mostly apply to fictional scenarios. In the case of across the board cuts, the average real budget has very few categories that can be cut in such a manner. In the case of checklists, most people do not have a long list of extravagant categories than can be easily cut, so it is also a fictional approach.

So having lambasted the usual suspects for cuts, I will now explain in subsequent posts the three methods that I employ to manage my costs. Anticipating the objections, I will tell you in advance that these methods all take a long time to work, require individualized attention, and require creativity to implement. So much for a free lunch! But which would you rather have: a fictional list of "easy items" to cut or a realistic (but nontrivial) approach to controlling your budget?