Central to the subject of personal finance is the concept of living within your means. In a nutshell, to live within your means is to spend less money than you earn. It's a basic concept which I'm sure most of us know and understand but for whatever reason we occasionally (or sometimes frequently) like to ignore it.
So many of the basic problems we all face with our money can be traced back to a failure to live within our means. High debt levels and minimal or non-existent savings are manifestations of the problem. And while you might be confident that you can make the repayments or borrow more money to cover any short-term cash flow problems, what if the unexpected happened.
In the current economic climate, the reality is that more people are losing their jobs. If you've managed to save some money and at least establish and emergency fund, you'll have a cash buffer if the worst happens. But if you've spent everything you ever earned (and then some) and suddenly you find yourself unemployed, would you be able to make ends meet?
Escalating credit card debt is a sure sign that you are living beyond your means. If the balance outstanding on your credit card is growing from month to month, it's probably time to take a step back and have a close look at your finances. How much money do you earn and how much do you spend? Be realistic about it. Remember if you're not saving any money and your debt levels are rising, there must be a shortfall somewhere.
Prepare a budget. Note down for a couple of months how much money you've spent and on what. You will probably be surprised. I know I am each time I go through that exercise.
Building wealth the old fashioned way requires you to establish a habit of saving. You'll be amazed at how quickly $50 or $100 put aside each week into a savings account will add up. Or alternatively, an extra $50 or $100 paid off the credit card will soon have it paid off and will free up the cash that was going in interest payments for use on other things.
You have your budget in place. You're spending less than you earn. You've started to save money on a regular basis and you're starting to accumulate a handy little pile of cash. So what's next? It's time to start thinking about another very important part of personal finance - investing.
Investing is the mechanism by which you will make your money grow. It is the act of buying assets which will grow in value and/or produce income over the years to come. Investing your current and future savings at a reasonable rate of return will help build wealth in order to reach your future financial goals.
But how do you get started with investing? Today I'd like to discuss a broad group of investment strategies which advocate a relatively simple and hands off approach to investing.
While most us us have heard of legendary investors like Warren Buffett, there is a theory floating around which says that the average investor wont do anywhere near as well as Warren Buffett. In fact they will struggle to beat the average because the average itself is made up of a bunch of average investors. Even more importantly, just to earn a return equal to the average should be considered a success.
This is where approaches put forward by The Coffee House Investor and others come to the fore. In a nutshell, they advocate the use of asset allocation and low cost Index Funds or Exchange Traded Funds (ETF's) to build your investment portfolio. Asset allocation is used to diversify across asset classes thereby spreading risk and reducing volatility. Index Funds and ETF's are used as a low cost way of ensuring an investor captures all of the return of a particular asset class - this is the very idea behind index funds.
You can see some of these types of portfolios in action at the Lazy Portfolios section of the Market Watch website.
Or for a more in depth discussion of the Ultimate Buy & Hold Portfolio from the Lazy Portfolios mentioned above, read The Ultimate Buy-and-Hold Strategy by Paul Merriman at FundAdvice.com.
I firmly believe that a personal or household budget is one of the fundamental building blocks when it comes to the subject of personal finance. A budget allows you to see clearly where your money comes from and where it goes. This is the very first step you need to take if you want to get in control of your finances.
Having said that, I've been a somewhat sporadic user of a budget as a personal finance tool. What I tend to do is prepare a budget and satisfy myself that my income does indeed exceed my planned expenditure by a sufficient margin to meet my savings goals.
What invariably happens then is that once I'm comfortable that my spending habits are roughly in line with the budget, I tend to neglect it until another (normally financial) event triggers me to go back and re-visit it. And that's what happened recently.
My wife has recently quit her job so it means we're down to one income. While it means a more relaxed family life for us all, it also requires a little more attention to the financial details of our lives. So in keeping with tradition, this event has prompted me to go back and update our budget.
The good news is that we still have an adequate difference between income and expenses to allow us to meet our savings goals. But the lower level of income caused me to cast a slightly more critical eye down the list of expenses to see where we could potentially save a little extra money.
Starting with some of the larger annual outlays, I fairly quickly identified 2 or 3 items which deserved closer attention. Adding together our phone and internet bills made it one of our larger regular expenditures. A little research quickly identified a number of better deals available to us for these services. In the end we chose a VOIP option in combination with our internet service. The cost is now roughly half what it used to be.
I plan on tackling some of the other larger expenses in the near future. I'm sure we could get a better deal on some of our other services if we shop around a little.
What prompted this cost cutting exercise was the preparation of a budget. It forced me to have a look at all of our expenditure in one place rather than in dribs and drabs as they actually occur. And we're seeing the benefits already.
I know that get rich quick schemes are enticing. The lure of making money fast is too tempting for some people to resist. Maybe there are some methods out there which you can use successfully to generate significant wealth over a short period of time. However, I suspect there is either a certain amount of luck, a large amount of risk involved or both. In fact the cynic in me suspects that the only people getting rich from some of these schemes are the promoters.
My plan to build wealth is simple. Spend less than I earn, save the rest and invest my savings in quality investments. I said the plan was simple not easy. And I can't claim it as my own either. It is essentially the story laid out in George Clason's personal finance classic, The Richest Man In Babylon. If you haven't read this book, I think you're missing out.
This deceptively simple formula does take considerable commitment though. Obviously it helps if you can maximize your earnings. This might be through developing your career or maybe via a more entrepreneurial approach.
Controlling expenditure is where most of us run into trouble though. A budget is one of the tools which is critical for managing money in this context. Knowing where your money goes is the first step to controlling your expenses.
Then, by putting a savings plan in place, ensuring that cash is being put away out of harm's way on a regular basis, you'll start to build up some capital to start up your investment portfolio. Untold numbers of books have been written on the subject of investment but the main point I want to make here is that you should strive to re-invest any income derived from your investment portfolio. Use the power of compounding to your advantage.
How does budgeting apply to personal finance?
Budgeting is one of the most basic personal finance tasks you can undertake. A surprising number of people have never even given this subject any thought and fewer still have even attempted to prepare one. So I have deciding to write a series of posts on personal finance budgets - what are they, why do you need one and how do you create one?
Today I will answer the questions - what is a budget and how does it apply to your personal finances?
So What Is A Budget?
A budget is generally a plan which is financial in nature and which maps out expected income and expenditure. Governments have budgets as do corporations. Governments need to understand how much expenditure is planned in what area and when the expenditure is due to occur. This then allows the government to plan what income is needed to cover these expenses. They then have the choice of adjusting taxation policies and debt levels in and effort to match expenditure against cash flows. In a similar way, corporations of all sizes will undergo similar activities to ensure continuing operations and profitability.
A personal or household budget is essentially to same as a government or corporate budget except that it is done on a smaller scale and at a micro level. Granted, an individual wont have the same financial resources as a government does, but the principle is the same.
So a budget is all about understanding what your expected income is over a given period and what your planned expenditure is.
Income could be salary or wages from paid employment. It could be interest on a bank deposit, dividends from stock market holdings or some other form of investment income. Income could equally be a government benefit, pension or other allowance. If you are helping your children set up a simple budget, it could just be their pocket money. Income could even be your regular winnings from the blackjack table or at the racetrack (only joking - nobody wins on a regular basis playing blackjack or betting on the races do they?).
Expenditure is anything you spend money on. This will be things like food, fuel, utilities, clothing and medical expenses. It also includes things like credit card payments, mortgage repayments and other debt servicing costs.
The other items that will appear in the outgoing section of your budget will be things like savings and investments. By this I mean the money you want to put aside each month to contribute to savings and investment plans. It's important to include these items in your personal budget so that they are part of your plan. Planning to save money is the first step on the way to saving money.
How Has A Budget To Do With Personal Finance?
A budget is one of the fundamental building blocks of your personal finance plan. It helps you to understand where your money is coming from and where it is going. You will use it to determine how much excess cash flow you have available each month (or maybe even how much shortfall there is). You can then put the excess towards debt reduction strategies to help you get out of debt. Alternatively you can put the excess to work in the stock market, a mutual fund, a real estate investment or any other type investment that will help you to grow your wealth.
And if you budget has a shortfall, you'll be able to identify it then take steps to address it. Maybe that car loan is too expensive. Maybe you need to re-think your personal loan rates. or you may just be living beyond your means.
Your budget doesn't have to be complex - a pencil and paper will do. However I suspect that excel spreadsheet budget planning is probably the most common method. In an upcoming article I will describe the process of actually preparing a budget.
For now, start thinking about where your money comes from and where it's going. Then keep an eye out for my upcoming article on how to prepare a personal finance budget.
What is the definition of personal finance?
Personal finance is a remarkably broad subject. The simplest way to define personal finance might be to take a look at each of the topics which come under the personal finance umbrella.
Record Keeping.
One of the fundamentals of personal finance is record keeping. It provides the foundation for everything else to build on. Keeping records means keeping track of all of your financial transactions. This includes what you earn, what you spend, what and where your savings (if any) are, insurance, and the list goes on. Record keeping can be as simple or as complex as you like. Some people will be thrive on tracking every individual cent that gets earned, saved and spent on a daily basis. Others will find this way too much overhead and will instead record approximate figures on a weekly or even monthly basis. Most people will find a working solution somewhere between these two extremes.
However you decide to do it, the main thing is to keep at it. Record keeping will enable you to understand what your financial position is now and how you've progressed over time. It will also provide valuable input into the planning process.
Budgeting.
Budgeting could be considered the counterpart of record keeping. The two go arm in arm. Budgeting is the practice of estimating future income and expenditure. To create a budget you would normally offset your expenses against your income month by month for the next year (and beyond). That way you can see what the surplus or shortfall is each month. This can help with planning your investments or by identifying where your future cash flow problems might lie.
Financial Position.
Another key area of personal finance is your financial position. Knowing this is key. When used in conjunction with your record keeping and budgeting, your statement of financial position is a key tool in meeting your financial goals. In it's simplest form, it's a document which lists your assets and your liabilities and which will hopefully show a surplus on the asset side. Even if it doesn't show a surplus of assets, it will provide you with a starting point on your road to freedom from debt.
Credit and other forms of Personal Debt.
And speaking of debt, this is another broad topic within personal finance. Not many of us can go through life without resorting to some sort of debt. Whether it's a mortgage to fund the purchase of a house, a personal loan to buy the car of our dreams or credit card debt to be used for day to day living and the odd larger consumer purchase, most of us will be in debt at some time or other.
But there are different types of debt. Borrowing money to finance investments can be a powerful wealth generating tool. However payday loans and other forms of cash advance are normally to be avoided if at all possible.
Saving and Investing.
Saving money is something we should all aspire to. It could be saving enough money to put aside in an emergency fund to provide a financial buffer in unforeseen circumstances. Or it might be saving for the kids' education or maybe even an overseas trip. And saving ties in nicely with budgeting. Saving is what we can do what the money which our budget tells us should be left over each month.
Then once you've accumulated some savings, you may look at how to invest them. Investing is a complex area with many complex investment products available. You might buy shares, real estate or a mutual fund. You can even invest in non-financial asset like art or wine providing you know what you are doing. Investing is how you take your accumulated saving and put them to best use to grow your wealth over the long term.
Insurance.
What does insurance have to do with personal finance? Well, what's the point in doing all of that hard work to get your personal finances in order just to see some catastrophic event wipe it all out? That's why insurance is such an important part of personal finance. Whether it's your house, your car, your income, your health or even your life, you need to make sure you have enough insurance for the worst case scenario.
Tax.
Nobody likes paying tax, but with some careful planning and good advice, you can at least minimize the amount of tax you need to pay. I'm sure most people would agree that we pay more than enough tax already. And by organizing our personal finances better, we may be able to reduce our taxes freeing up more money to save and invest.
Retirement Planning.
For some people this is what it's all about. You need to make sure that nest egg has grown large enough to support you once you stop paid employment. By putting the right strategies in place earlier in life you can help ensure you have a comfortable retirement.
Mastering each of the above topics should put you well on the way to living large in retirement.
Estate Planning.
They say that death and taxes are the two certainties in life. While nobody likes to think about their own mortality, it's important to consider your estate. How should it be distributed? Do you have any special wishes? Is your will up to date? A little planning and forethought may at least remove some of the financial worries from this difficult time.
I think the topics above cover this broad subject area reasonably well. In future posts, I will refer back to this "What Is Personal Finance" post often as I drill down on each of these topics.
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