ITS STUPID TO SAVE WHAT’S LEFT AFTER SPENDING!!

ITS STUPID TO SAVE WHAT’S LEFT AFTER SPENDING!!

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This will be the concluding post in my series on ‘Budgeting’ before we begin discussing Life Goals, leading to a Life Plan directed at achieving them. This post is in three parts:

  • Why and how should the savings process be made automatic.
  • How can we manage those dreaded month end blues?
  • Why should your FIRST priority be to create an “Emergency Fund”?

Before we go ahead, I believe it’s critical to clarify that, one should not to confuse ‘saving’ with being ‘miserly’. At best one could associate saving with “frugality” which the Cambridge Dictionary says is ‘being careful when using money’.

On the contrary, a ‘miser’ is some one that wants money but hates to spend it. Whilst misers bring misery upon themselves and their family through unfulfilled needs (let alone wants); a frugal person is a prudent one who can differentiate between “wants” and “needs”. I believe frugal people whilst questioning the need to spend money will invariably place utility ahead of any urge for being ostentatious. They usually step back to ask themselves if there could be other better uses for that money. They also strive to quickly become debt free and then stay that way. They also work hard at managing the stresses that could result from unforeseen financial emergencies.

“DO NOT SAVE WHAT IS LEFT AFTER SPENDING – BUT – SPEND WHAT IS LEFT AFTER SAVING”

Says Warren Buffett …… So, how does one execute Mr. Buffett’s advice?

Quite contrary to what we imagine, psychologists don’t believe we humans are really as rational as we pride ourselves to be. Daniel Kahneman (Author of Thinking Fast and Slow; a psychologist who won the 2002 Nobel Prize in Economics) divides our cognitive process into: (a) System 1 – fast, intuitive, reactive, instantaneous decisions which actually govern most of our lives and (b) System 2 – those decisions which involve complex analysis for exercising self-control or even tasks which may involve physical risk or danger.

Money decisions on a day to day basis are taken by System 1 except when, they involve a level of intricacy which require intricate financial analysis.

CLICK HERE: For the Review of “Thinking Fast and Slow”

What Mr Buffett suggests is a creative idea to trick your mind into limiting the System 1 from taking spending decisions – to only that one time (hopefully) when we set up the automatic mechanism.

Well, it’s now time to put into use all your painstaking effort that went into preparing the “Income & Expense Statement” and get it working for you. Let’s begin with summarizing all your Cash Flows as follows:

  • (a) The amount you receive as “Salary Credit” every month
  • (b) Total Monthly Expenses
  • (c) Total of all Expenses Due Quarterly; divide by 3; to arrive at the per month portion
  • (d) Total of all Expenses Due Half Yearly; divide by 6; to arrive at the per month portion
  • (e) Total of all Expenses Due Yearly; divide by 12; to arrive at the per month portion
  • SURPLUS = [(a)} Less [(b)+(c)+(d)+(e)]

Read and “diligently” execute the fine print in the chart below:

What you have actually achieved is the “automation of your savings process” and as a result, set aside in the SB A/c: Deferred Expenses; Rupees to pay for expenses that you have already expended but will pay for later (now, without upsetting your cash flow in the month they are demanded) and more importantly, into your SB A/c: Accumulations; Rupees to be allocated towards planned Life Goals (which we will discuss in great detail on this Blog).

You must have noticed that, I have not specifically mentioned the nature of payments which should obviously include insurance premiums, various loan EMIs and even the Minimum Amount Due (usually 10% of balance on bill date) on your credit card/s. Always remember, its cash outflows that we should be concerned with.

Mr Buffett should be mighty pleased with you – after all, you will be “spending only what’s left after saving”.

Of course, that is not to say you cannot pull out the money you have set aside and BLOW it all up but now, I can assure you that, doing so will become a System 2 decision. Your mind will undoubtedly demand that you justify this action (to yourself of course) and hopefully put the brakes on your impulsive behavior.

Life Planners call this “paying yourself”!

– it’s the money you pay yourself for having worked hard to earn that salary, so that you can provide for yourself a much-deserved carefree retirement and the well being of your loved ones.

THE NEED TO PREPARE OURSELVES FOR FINANCIAL SHOCKS AND HOW TO DO IT.

The Pew Charitable Trusts’ conducted a Survey of American Family Finances and one of its outcomes was a ‘Report on the Role of Emergency Savings in Family Financial Security’.

CLICK HERE to read the full report (Jan 2016)

My takeaway from that Report in summary is: Many (rather most) households are perennially at risk of suffering financial shocks and these shocks can prove very disruptive to their financial well being because they could completely derail their finances; and getting them back into order could prove an uphill task.

I can hear you asking the reason for me taking up a report on US households. Let me assure you that, its findings are as much applicable to us as they would be for anybody else living anywhere. In countries with meagre per household capita incomes (in comparison with the USA) we may in all probability be even more vulnerable.

Figure 1 in the above Report indicates that about 70% of those surveyed believe that, they suffer financial shocks every few months. These shocks need not be calamities but their impact was  enough to derail their cash flows.

Surely, access to a distinct pool of savings kept aside to help these households tide over those disruptions in their cash flows would greatly assist in reducing their intensity. For the financially disorganized even those expenses which fall due in cycles beyond the month can prove disruptive. By adopting the discipline and self control in “automating our saving process” as described above we would have successfully separated our monthly expenses, deferred expenses and savings – this is the first step in dealing with “financial shocks”.

If we were to recognize the uncertainties around our health and the resultant medical expenses, our jobs and therefore the ‘source of our income’ ; it would be a no-brainer to acknowledge the need for a distinctly invested “Emergency Fund”.

Let’s address the key questions that arise in our mind when we talk of an “Emergency Fund”. 

  • How big should the amount be?
    • I would consider [(b)+(c)+(d)+(e)] as one month’s amount (M). That way we will have provided for EMIs, insurance premiums, etc.
    • As a thumb rule older the person, higher should be the number of months (of M) kept aside.
    • Begin with the very minimum : Up to age 30 years – 3 M; 35 years – 4 M; 40 years – 6 M; 45 years – 8 M and 50 years+ – 12 M. 
    • Its logical to expect that, EMIs and Insurance Premiums will reduce as we get older. Also, whilst your income increases with the progress you will make in life, your disposable income should increase whilst living expenses would not increase proportionately. Therefore, as a result reaching a 12 M equivalent amount should not be too big a worry.
  • How should I invest it?
    • Safety and liquidity should be the only two criteria one should be concerned with here (not returns).
    • I would place this money in an “Ultra Short Debt Fund” (preferring a portfolio of AAA credit quality, even if you have to sacrifice up to 75 basis points i.e.0.75% pa, in returns) with a reputed fund house.
    • In case either you or your spouse enjoys a ‘low or no’ tax status and has an independent source of income; you could make a Bank Fixed Deposit, in their name and yours second (Either or Survivor).
  • If I have debts, should I repay them before beginning to build it?
    • The logical response would be to repay the debt – if it costs more than the returns you make on your investments. However, life after all is not all logic and math!
    • My response would be to keep my mandatory repayments up to date and salt away as much as I can, to build my emergency fund as quickly as I can.
    • The emergency fund should be built on high priority even before one commences accumulating resources for any other goal (long term or short term).
    • Extreme measures need to be adopted, which could mean cutting back on all ‘discretionary expenses’ (including holidays, pubbing and eating out) and stashing back presents, windfalls and bonuses. For the more talented, I would even encourage a “side hustle”.

Finally, you have the challenge of managing those dreaded “month end blues”.

The above report makes an interesting observation: “Families’ perceptions of financial security differ depending on whether it is early or late in the month”. Sounds familiar? I would recommend the following arrangements be put in place as you advance in building up your emergency fund.

  • Always have one month’s Net Salary equivalent in cash, securely stashed away at home.
  • Avail of the “Salary Overdraft” facility from your bank. A ‘limit’ of 1 to 2 month’s salary is normally extended at lower interest rates with “salary accounts”.
  • Avail of the Credit Card facility (usually comes with Salary Accounts) also with a limit of up to 2 months salary.
  • Buy a “Medical Insurance Policy” provided your employer does not provide one to you.

1: Do not borrow under the overdraft or the credit card – They should never be used to borrow except in an emergency or pending availability of the cash from investments earmarked for the emergency fund.

2: Use the overdraft facility only to tide over “minor shortfalls” at the end of the month, mainly arising from timing differences.

3: That “small overdraft” should be repaid in full – when your salary gets credited. Never roll-over (i.e. carry forward the borrowing to the next month) your credit card balance – always have an “auto debit” to repay it in full. However, always ensure to have at least an “auto debit” to SB A/c 1, for 10% (or whatever the stipulated minimum) balance on “Bill Payment Date” – that way you will never default and harm your credit rating.

That concludes the series on ‘Budgeting’ – I have for your ready reference, provided you below the links to the earlier posts on this topic. I do hope you have found it of use ( Personal finance is boring, so I will not expect you to have enjoyed reading it!!).

However, I will even at the cost of sounding pedantically repetitive say that, whilst understanding it conceptually is the easy part; the real challenge is in its execution.

Published on October 24, 2017: Saving is more difficult than investing

Published on November 14, 2017: What does your “financial snap shot” look like? Check it out !

Published on November 20, 2017: What they never tell you in school about the “Magic of Compounding” money !!

Series on Life Goals – Their identification, definition and achievement. 

 

 

 


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