Monday, September 12, 2011

Budgeting: Part 28: Holding It Constant

"Gain may be temporary and uncertain; but ever while you live, expense is constant and certain."

- Benjamin Franklin

The way I have managed our household budget over many years is very simple:

1. Start with detailed, accurate tracking data for both income and expenses.

2. Make a yearly baseline.

3. Track the current year against last year.

4. As the year progresses and one budget category begins to track high for a given month, simply adjust other months or categories to compensate.

5. Some years I allow an inflation adjustment for spending, but for most years, I try to hold current year spending to previous year spending with no inflation adjustment.

Now you might be thinking to yourself: isn't this just the way most people adjust their budget on an ad hoc basis? No. From what I read in articles and discuss with people, it's actually just the opposite of what most people do. Most people intuitively estimate their spending, and then attempt precise, methodical adjustments to it. I'm suggesting that a better way is to precisely track your spending and then intuitively make adjustments.

If you fully grasp this difference, it will go a long way towards understanding this entire budgeting series. I'm sure there were people who read all these sections on tracking and did not see why it was necessary to be that thorough and precise. Does this level of precision really matter? Do we really need that level of detail? Why not just see how much money you have in the bank at the end of each month? Can't we save money without all that tracking effort?

My answer is that of course you can be frugal, financially responsible, and save a lot of money without all that tracking. However, you cannot do what I'm suggesting in this particular article without it.

The idea that you can perform like a servomechanism to hold your budget constant is predicated upon the idea that you receive prompt and accurate negative feedback. I really believe that most people would intuitively adjust their budget properly if only they had the right data to operate against.

But most people have only a very rough idea of where their money goes. They don't know how much is spent of what things. Even those who think they know are often wrong due to faulty memory, personal bias, oversight, accounting shenanigans, and a whole host of other issues. Now imagine that as a backdrop against trying to adjust for 3% inflation in expenses year over year. If your tracking is potentially off by 30%, 40%, or 50%, it's useless to try to adjust for 3% -- that is noise compared to the uncertainty of your existing numbers!

Now you certainly don't have to do your budgeting adjustments this way - I'm sure there are many other successful alternatives. But I'm describing an approach that works for me, and if you want to try it, then you have to be prepared for the prerequisite, which is a thorough and accurate accounting of your spending.

Over a period of many years, you can achieve amazing results by holding your spending constant while receiving a cost of living raise at your job. For example, suppose that right now you are spending everything you make and that it's realistic for you to receive a 3.5% raise each year to compensate you for inflation. If you can hold your spending constant each year while receiving an inflation raise in your income, in 5 years you will be saving about 15% of your income. In 10 years, you'll be saving about 30% of your income; in 15 years, you'll save about 40% of your income.

However, in order to combat inflation year after year, you will probably need more than just simple adjustments and willpower. It's extremely difficult to swim against the tide of inflation for very long. In the next article I'll describe the method I use to keep long term inflation under control.