This is the 3rd post in building out a proper personalized financial plan. Budgets and cash flows are one of the most important determinants to a sound plan since your spending determines a number of the inputs we will calculate around retirement needs, insurance and savings requirements.
Tracking Your Spending and Creating A Budget
The first step to saving is to understand where your money goes. The bad news is that if you have never done a budget, the first time you review a year’s worth of spending will be time consuming. You will need to go through all your bank accounts and credit card statements to track the outflow of funds. The good news is once you complete the review of last year, there are excellent software apps that can help you track spending moving forward.
I should mention that if you have a significant other, being open and honest about spending is very important. It won’t be much use if the year review only covers half of the household spending. Lack of clarity on money in a relationship can lead to mistrust or fighting. I don’t advocate a specific way to act around spending. Whatever approach to money that is decided upon should be individually tailored to your personalities and relationship. I do think that talking about money is important and the first budget experience should be as non-judgmental as possible. Remember, financial planning isn’t about obtaining a bunch of money just to feel rich. It is about realizing your family’s financial goals, which should amalgamate what your family values and priorities are for happiness in life. You are aiming to be as intellectually honest with your spending to find places where some adjustments are realistic .
The picture below is an example (courtesy of http://www.frugalfanatic.com/) of a household expenses summary that covers all the main categories. You can obviously personalize it as needed but I often separate out groceries, fast food and dining out/entertainment. I find this helps me understand why food spending might be changing (working more, new baby, vacation etc)
Given that this blog is trying to focus on professional specific advice, I will let you read up on saving techniques yourself. There are numerous personal finance blogs that cover this topic better than I can. Certainly mrmoneymoustache.com will give you a huge number of spending adjustments to consider. I have mentioned previously my family no longer comes anywhere close to the lower level of spending we had when we lived like a resident and were never close to a moustachian-like budget. We never used coupons and I wasn’t scouring over the monthly expenses looking to optimize our spending. Reflecting on our past, I think the list below were the main areas we saved relative to other professionals. Other general principles applied were negotiating on big expense purchases and always trying to reduce or eliminate any long term monthly recurring costs.
1. Rare extravagant dining
2. Bringing lunch to work vs buying
3. Never buying a $5/day coffee
4. Cutting the cord/big cable cost – Our internet/TV/movies/landline cost has never exceeded $70/month and for many years was just internet cost.
5. Negotiating a good cell phone package that we kept as a legacy for a long time
6. Targeting a limited number of eating out occasions/month
7. Buying our “nice” consumer goods like furniture or kids stuff via Craigslist instead of brand new with associated taxes.
8. Reduced housing expenses – this is relative to our local market but certainly not on an absolute basis given we are in Vancouver!
9. Cheaper style travel – This definitely only applies to early on. We spend way more than I would ever like to admit on travel now!
10. A true perception shift where many consumer goods looked like temporary instant gratification versus truly improving our quality of life. This tended to limit purchases that would lead us to just accumulate more “stuff”.
Once you have completed your retrospective spending analysis, you will likely have a few things that will jump out and surprise you regarding the amount spent. Most people think it will be excessive shopping or travel. However, the most common one is fast food or coffee because the cost seems minimal for each individual purchase yet adds up quickly. Groceries and dining out will also surprise many people.
Once your first budget review is complete, you have an intellectually honest view of where all your money goes and can attempt to see if small changes can be made to save more. I suggest starting with realistic changes so that you don’t feel any real sacrifice in the beginning of your spending adjustment. Luckily, there are multiple tools to help track consumer spending and follow budgets. My favorite budgeting tool is Mint which can link up securely to your different spending accounts and track all major categories of spending. Mint can also practically serve as a net worth tracker as well. I personally feel somewhat uncomfortable having all my accounts listed online along with my net worth, even though Mint is supposed to have banking level security encryption. I currently do 95% of my consumer spending on credit cards, so I have linked these credit cards to Mint in order to track our spending habits. I then separately add up the expenses coming out of chequing accounts. Mint also allows you to set goals to particular types of spending where you want to attempt to adjust your habits. For example, if you wanted to reduce fast food and dining out to $200/month, Mint will send a real time warning if you are nearing your allocated budget. This type of feedback is far more useful than when I used to do pen and paper budgeting reviews once a year.
Once you have done a summary of your budget, you can now have a clearer picture of yearly cash flows. I create a few categories to view cash flows:
a) Earned Household Income
b) Earned Investment or Rental Income – this would be only income received from these assets, not any paper gains on their value
Total Income = a+b (represents Total Positive Cash Flows)
c) Firm Fixed Costs – Housing, Utilities, Insurance, Child Care, Basic Transport, Professional Dues, Dental and Medical
d) Mostly Fixed Costs with Some Flexibility – Groceries, Basic Clothing, Phone, Taxes (more on this in the Incorporation post), Debt Servicing, Basic Household Necessities
e) Discretionary Costs – Entertainment, Charity, Eating Out, Travel, Cable, Luxury Items (any item in the fixed costs category that you spend more than the average person for something nice)
Total Costs = c + d + e (represents Negative Cash Flows)
As a professional who is incorporated, I don’t separate out corporate vs professional spending mainly because I don’t have a formal office and am a hospital based physician only. Our corporate spending has stayed identical for 5 years and is a relatively low fixed cost. If I did have an office, I would likely create a separate corporate costs spreadsheet with similar categories to try to find areas where cost efficiency can be improved. I hope to find an office based professional to do a guest post at some point to help discuss optimizing your office – fire me an email if you are interested.
With the above categories, you can now estimate your available cash flows for savings or debt repayment: Total Income – Total Costs = Available Yearly Free Cash Flow
I then break down the data from yearly to monthly as it is easier to track trends. This whole cash flow exercise is pretty simple, but it helps inform many future decisions in financial planning including:
1) Estimated Future Retirement Spending
2) Yearly Savings Potential
3) Debt Repayment Potential
4) Estimated Retirement Age
5) Potential Efficiencies in Taxes and Spending
Which Matters More – Better Savings or Better Investment Returns?
Most people think having huge gains in the portfolio from large investment returns is the biggest factor for rapid wealth accumulation. I just showed the huge importance of compound interest in a prior post. I’m sure a few readers started playing around with some of the compound growth calculators and saw that if you change long term returns from 8% to 10 or 12% over a long period of time the difference in final wealth can be staggering. It is true if you can compound money at very high rates, like Warren Buffett at over 20%/year for a very long time, you can be far wealthier than you could ever save. The issue is that this is incredibly hard and Warren Buffet is a statistical outlier. In my opinion, these are the realities about investing:
1) It is very easy to achieve lower than market returns secondary to the numerous investing mistakes that are possible. Most average investors fall into this category.
2) It is fairly hard to achieve just average market returns for the long term. Index or ETF type investments are the best choice here, but poor investor behaviour can and often do lead to sub-par returns.
3) It is EXCEEDINGLY hard to achieve even a 1-2% greater than market returns over a long period of time. The vast majority of money manager professionals do not achieve above average market returns over the long run. It is often quoted that 80% of money managers do not beat the market after fees! These individuals study their craft diligently the same way you have for your profession. The failure of these individuals is clearly not for lack of effort. The majority of the failure relates to fees, performance chasing and closet indexing which we will discuss in the post about mutual funds.
Yet even at the extreme end of the standard deviation curve where Warren Buffet sits as one of the greatest investors of all time, he is only getting a multiple about 2.5x the average stock market return. There is a different wealth creation lever that can be adjusted to achieve up to a multiple of 7-8x the average person. The current average savings rate in Canada in hovering between 5-6%. It is far more within your power to adjust your savings rate by vast multiples than you could ever dream of doing with your investment returns. My personal belief is 80-90% of achieving financial independence is about early aggressive savings and only 10-20% from investing results (which is mainly from not making stupid mistakes and letting compounding do its work). As professionals, you can truly achieve 35-50% savings rates without feeling like you are suffering horribly in your quality of life.
Investing is far more exciting to discuss than saving and therefore gets most of the attention in personal finance. Even as the writer of the blog, I’m feeling a bit antsy wanting to discuss the investing side given that is far more interesting and thought provoking. I do have multiple investing concepts that I apply to my personal investing to optimize it as best as possible. These will all be valuable to you and I will go through them all once the core investing foundation is established. I just want to strongly emphasize how much more important your saving habits are than investment selection. This fact should also make you feel more empowered to be in control of your own financial fate.
This budgeting and cash flow exercise seems easy, but sitting down and actually doing it can be initially tedious. It is also one of the financial planning tools that you likely haven’t utilized properly despite having a financial planner. A planner may ask you to generally target a higher amount of savings, but it is difficult for them to tell you how to adjust your spending habits. Spending is directly related to your lifestyle and is quite a personal matter. The only person who can influence your spending is you. I strongly suggest you take some time on this part of building your personal financial plan as this will be the biggest determinant of your financial health moving forward.