A few years ago, I received an e-mail from a couple seeking a portfolio makeover. They were in their mid-50s, and their portfolio had been taken on a wild ride during the financial crisis from 2007 through early 2009. That, in turn, had scuttled their hopes for retirement in less than a decade, and they were wondering how they could make up the lost ground.
This couple's investment portfolio, with more than 80% in stocks, was clearly too aggressive given their life stage. In talking with them about their finances, however, I discovered that their investments weren't their main problem. Their spending was.
The couple had scrimped and saved to buy a carpet-cleaning business in the early 1990s and went through some lean years while they were building up their clientele. Thanks to their sacrifices and hard work, the business was generating more than $200,000 in take-home income per year.
As is so often the case, however, this couple's spending went up right along with their pay, and their savings slowed to a trickle. They bought a bigger home, took regular trips to Las Vegas, and were in the habit of spending money on nearly anything they wanted, from flat-screen TVs to catered family parties.
When I asked them if they had a budget, they said that they once had. While they were buying and building up their business, they lived in a two-bedroom apartment with their two children. But after their income had increased to a more comfortable level, they didn't see as much need for budgeting and eventually stopped tracking their expenses altogether. When they tried to look back on what they had spent over the past month, more than $1,500 was unaccounted for. I pointed out that if they were to save that amount each month rather than spend it on stuff that they couldn't remember, that would do far more to get their portfolio back on track than selecting the right investments ever could.
Because we all have a natural tendency to spend what we have, everyone needs a budget, regardless of age, life stage, or whether we think we've "made it" or not. The key point about a budget is that it helps ensure that your spending syncs up with your priorities. This couple wanted to balance their here-and-now goals of travel and fun with their long-term goals of funding a comfortable retirement and perhaps leaving a legacy for their children.
Here's a quick overview of how to create a budget you can live within.
Step 1: Enter your current fixed and variable expenses, as well as information about your sources of income, on this Budget Worksheet. For expenses and income sources that don't fit neatly into the categories provided, use the "other" lines. If you have several expenses of a given type, make a note alongside the line item--for example, "DVD Rentals" or "Toiletries/Makeup."
Also record any savings that you're typically able to set aside each month.
Step 2: Start the budgeting process by scrutinising your variable (or discretionary) expenses over the past month(s). Because you have the most control over this set of costs, making adjustments here is the fastest way to improve your household's financial picture.
Be forward-looking as you evaluate your variable expenses. The data you've supplied about your income and spending provides a snapshot of the money you have coming in and going out. But your budget gives you a chance to shape your spending to fit with your goals, both personal and financial. For example, you may have spent a lot on takeaway and restaurant meals over the past month. But if getting in shape is on your list of personal priorities, you can tweak your budget to reduce your spending on restaurant meals and increase the pounds that you're allocating towards food from the supermarket so you can prepare healthy meals at home.
As you go through the process of evaluating your variable expenses, it's also essential to be realistic. Just as dieters can't stick with the plan if it doesn't allow for the occasional piece of birthday cake or glass of wine, it's also unrealistic to plot out a budget with no room for the occasional movie or lunch with friends. Using your real past expenses as a template for your budget helps anchor you in reality, not a pipe dream.
If you anticipate expenses that are predictable but not necessarily monthly--such as holiday and birthday gifts--it's a good idea to distribute those costs throughout the year. Look back on the past year's worth of gift giving, estimate your expenditures, and adjust downward or upward as you see fit. Then divide by 12 to arrive at your monthly budgeted amount.
Record your target expenditures for each line item in the Budget column on the Budget Worksheet.
Step 3: Next, turn your attention to your fixed expenses on the Budget Worksheet. Although household necessities are usually referred to as fixed costs, that's a bit of a misnomer. Yes, these items are necessities, but you may be able to adjust them somewhat. Among the areas where it's possible to reduce your fixed costs are:
-- Food
-- Clothing
-- Credit card interest rates (sometimes, but not always, negotiable)
-- Mortgage payments (if refinancing is an option)
-- Telecom services such as landline phones, mobile phones, Internet service, and cable TV/satellite (you may be able to change providers or negotiate a lower rate with your current provider, especially if you're purchasing more than one service)
Take note of the areas where you may be able to reduce your fixed costs and plan to follow up on them. If you are able to obtain reductions in these areas, adjust your budget accordingly.
Step 4: As you tweak your target expenditures, pay attention to how the changes affect your bottom line. Your goal should be not only to balance your household budget but also increase the amount you have earmarked for saving and investing each month.
Step 5: Finally, put in place a plan to check your real-life spending versus your budget on an ongoing basis. One of the key mistakes that people make when budgeting is that they create a budget and then put it in the drawer.
Start by finding a place to record your household's expenses. Software programs like Quicken can help you track your expenses, but you can also track them with a pen and paper. Be sure to ask your spouse to do the same.
Next, block out time on your calendar each month (ideally, one hour per month over the next three to six months) to check up on your actual expenses versus your budget. If your first budget assumptions were unrealistic or if something material has changed in your household's financial picture, adjust your budget accordingly.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar Inc.
