Budgeting Part 3 – How to Reach Your Financial Goals
Market Meditations | July 22, 2021
? Mental Models
We often write about various mental models and how they can impact your success whilst investing. Understanding how these impact your personal finances is just as essential.
1️⃣ The Ostrich effect: This reflects one of the biggest obstacles to putting together and sticking to a budget. It describes our tendency to avoid negative information even when it could provide feedback to help us improve. How many times have you avoided looking at your bank statement simply because you didn’t want to see how bad your spending really was. Be kind to yourself, focus on the big picture and you will be able to avoid this obstacle.
2️⃣ Second order thinking: First order thinking is simply, how much will this cost me today, second order thinking however, is what are the future impacts of this purchase? For example, a car has running costs, costing you even more money, however a good pair of work boots may save you the need to buy a cheaper pair every 2 months, saving you money in the long run. Think about second order effects and make financial decisions accordingly.
3️⃣ Commitment Bias: The budgeting process may reveal evidence of previous poor decisions. Instead of falling foul to commitment bias, learn from your mistakes and make decisions that result in the best future outcome, not one that is rooted in the desire to believe your previous decisions were correct.
4️⃣ Social proof: When we feel uncertain, we tend to look to others to guide or validate our own actions. Our budgeting process should have revealed what is important to us and how we want to spend our money. Don’t look to those around you for validation – play devil’s advocate, always make your own decisions and live your best life.
5️⃣ Mental accounting: This is where we subjectively assign value to an amount of money based on how it was earned or how we intend to spend it. Whether the cash is hard earned income or a from lucky trade – it should always be treated the same. Similarly it can be easy to mentally assign your savings to specific events such as a holiday. However if that money could be used to pay off a credit card bill avoiding a large interest payment, you may want to reassign it.
?️ Financial Willpower
No matter how much we work on our psychology and understand inherent biases, we are all prone to lapses in judgement. It has been shown that humans perform worse after having to make decisions, and that this effect is exaggerated when these are important or emotional. Times of reduced willpower can result in impulse spending or digging into our savings when we don’t need to. Therefore willpower management is an essential component of financial success and there is one workaround that reigns supreme; automation of your finances
Automating your finances removes all active decision making from your process, meaning that (1) it is effortless to stick to your budget and (2) you will have more willpower to spend on other matters (such as earning more!). So how do you do it?
- Pay yourself first. This is the most important rule of automation. Set up automatic payments from your main account (where you receive the majority of your income) to your savings and investment accounts. This means you actively have to remove money from these accounts in order not to hit your goals. You can go one step further and automate not just the deposits but the investments themselves (such as an automatic purchase of an index fund each month).
- Set your bills to autopilot – make sure all your bills, especially credit cards are paid off in full each month automatically. This both avoids any unnecessary late fees or interest and often makes your utility bills cheaper!
- Guilt free spending – Similar to the first tip, automatically move your discretionary spending for that month to its own account. That way you won’t spend too much on luxury items but when you do decide to make a purchase, it will be completely guilt free.
? Budgeting for the Future
So we should now have the tools to think about our budgets in a healthy way and the methodology to manage the willpower required to stick to a budget. But what happens when something changes?
At this point our emotions can run wild. We may feel ecstatic that we have received a promotion and feel like splurging on a new car or we may have accepted a pay cut and feel like we have to cut 100% of luxury spending. The key is to always have a plan for a change. Don’t allow your spending to creep up if you start earning more and if earning less, try and spend on things you really love. Do this by thinking about your priorities beforehand. If I earn more do I want to reach my goals faster or do I want to spend more on holidays? If I earn less, what items am I spending money on that I can do without?
It is also important to continuously review your spending habits. Now this is not a case of going through line by line and calculating exactly what you are spending money on each month – that is unrealistic and something that most will never stick to. What’s important here is simply that we have a rough understanding of whether we are spending money on the things we have established that we value most!
Life goals can also change! The things that made us enjoy life one day may not the next. As well as periodically making sure we are executing our plan, we should also be sitting down and thinking about what truly makes us happy. This may reveal different results to when you initially put together your budget. When this is the case, amend your budget accordingly and make sure you are always budgeting in order to live a life you enjoy.
✅ Pro tip: Thinking about what you want out of life does not just affect your budget but how you spend your time!
Money is a tool. A tool that allows us to embark on life’s journey in a way that is right for us. For some that means luxury holidays and lavish spending, for many it simply means being comfortable – no one is the same. Use this guide, get to grips with your finances and start living life in a way that is right for you.