When it comes to money, as Clint Eastwood said to Gene Hackman in Unforgiven (the best western since the ’70s and perhaps the best of all time), “Deserve’s got nothin’ to do with it.” I believe that it’s more than okay to spend money on nonessential stuff; it’s entirely necessary. If you don’t spend money on the things you enjoy, what’s the point in having money? But there’s a huge difference between “I deserve it” and “I can afford it.” We have to take “deserve” off the table. What do I mean by that? You work hard, you save money, and then you see something you want. If you’re going to stay solvent, you have to ask yourself: can I afford to buy this? What you cannot afford is to think that good financial behavior should be rewarded by the kind of outrageous discretionary spending that gets people into credit card debt. You should treat yourself, but within limits—the limits of what you can afford.
How do you determine what you can afford? You make a budget—but it has to be the right kind of budget. Merely planning how to make ends meet with some savings left over every month probably won’t get you there. This is my basic issue with how most people write about and handle budgets; it’s always too short-term. You should budget to avoid becoming poor, and your time frame should be your whole life. That’s because you’re not going to lose everything you own this month, and even if your finances are in bad shape, you probably won’t see destitution coming even a year away. That’s why when you budget, you should budget for a lifetime.
How does that differ from the standard approach? Let me give you an example. There was a great article by Brett Arends on TheStreet.com, where I work and where I’m the largest shareholder, that came out right after the iPhone was released. It was called “The True Cost of an iPhone? Try $17,670.” Arends was making the point that if you took the $600 you spent on an iPhone, plus the cost of the required two-year service contract with AT&T, and instead invested it in your 401(k), it should be worth about $17,670 when you retire and start withdrawing money from your retirement account. The same holds true for any other expenditure; Arends was just using the iPhone as an example. Now, I don’t believe for one second that you should always give up spending money on things you enjoy in the present in order to have more money in the future, but if you want to stay out of the poorhouse, and especially if you want to get rich, you have to think like this. Buying something with a credit card and not paying off your full balance for months or years makes everything you buy much more expensive and seriously undermines your ability to stay solvent or generate long-term wealth.
I know that thinking thirty-five years into the future every time you buy a bar of soap doesn’t make any sense. But when you put together a monthly budget for your household, long-term considerations are important. You have to ask yourself where you’re going to be in ten years, or twenty years, and you cannot let hope get the better of you. Many people, especially young people, assume that in the future they’ll earn much more money from their job than they do in the present. That may happen, it may not, but planning your future based on that assumption will more often than not result in your getting hurt. Remember, your paycheck isn’t enough. Counting on a bigger one is not a strategy.
The first rule of budgeting, and just about everyone will agree with this, is that you have to make a budget. Even if you don’t hold to your budget stringently, laying one out gives you a sense of what you can and can’t afford. It will show you where you can spend less and save more. Making a basic budget is easy, as long as you’re honest with yourself. Look through your expenses for the past month and the past year to cobble together an idea of what you’ll have to spend on the necessities and what you’ve been spending on discretionary stuff. This will tell you what you need going forward and what you can do without. It will tell you what to change, but you have to know how to look at a budget before you can figure these things out. I’ll explain.
Budgeting for the long term is about both trying to become rich and trying not to become poor, but at the end of the day these two goals differ only in their motivation, not their outcome. Getting rich is about greed, staying out of poverty is about fear, but each should encourage you to save money. How much of your paycheck should you save? How much should you spend on a place to live? On transportation? Food? These questions are, to some extent, pretty open-ended. How rich do you want to be? How secure do you want to be? Those are the two most important questions when planning a budget. The more wealth you want to build, or the more financial security you want to ensure, the less you have to spend. It really is that simple. You know that savings are about building the capital you need to invest and thus become wealthy. Saving does increase your financial security, but from the perspective of fear, a good perspective that keeps you healthy and out of the poorhouse. Spending less money on certain things is about averting disasters.
So how do you go about putting together a solid long-term budget? There are six steps to smart budgeting for life:
Step 1. Learn from the past. You need to put together a comprehensive record of your past income and spending.
Step 2. Judge your past. Look at your records to determine how much less money you could have spent.
Step 3. Create your short-term budget. Using your records as a guideline, put together a reasonable budget for the next three months and the next year. You don’t have to live a totally Spartan lifestyle to maximize your savings, but if you can be happy doing that, then there’s no reason not to.
Step 4. Create your long-term budget. Turn your short-term monthly and yearly budgets into long-term budgets by planning your future expenses. For example, if you think you’ll buy a house in five years, include that in your budget and figure out a way to pay for it.
Step 5. Hold yourself accountable every month. At the end of every month compare your actual spending with the budget you planned and figure out where you’re beating the plan and where you’ve fallen short. After the basic step of simply putting together a budget, this may be the single most important thing you can do to plan for long-term wealth. By examining how your actual spending differs from your projected spending, you can nip any serious problems in the bud and learn how to correct your mistakes before they start making your life difficult.
Step 6. If you fail, take drastic measures. This is only for people who have trouble sticking to a plan. If you really find you cannot meet your goals no matter what you do, you need to take drastic action. For example, many people try to automate as much of their spending and saving as possible. You can automate most of your recurring bill payments, either through your bank or by calling or accessing the website of whomever you need to pay, whether your cable company or the bank that owns your mortgage debt. You can also automate payments into a retirement savings account like a 401(k) or an IRA, and once you’ve contributed money to those accounts it’s prohibitively expensive to take it out. I recommend this course only for people who have no success holding themselves to a budget. I believe that saving, and the investing that comes with it, should be an active process, not an automated one, and I think that most people are smart enough to take care of this stuff on their own. Automation should be a last resort, not an integral part of everyone’s budget.
Let’s get more granular. There’s a lot of great budgeting software on the Web, but you can add up your past budgets and create future ones with a legal pad and a pen. You don’t have to do this my way, but it’s important to standardize your budgets. Divide your record of past income and expenses and your future budgets into four columns. The first column is for your investments, the second column is for your income, the third is for your necessary expenses, and the fourth is for your unnecessary or discretionary expenses. Most people focus on their income and their expenses when they create a budget, but because your investments are how you’re going to get rich and how you’re going to take care of yourself, I consider them the most important thing to keep track of. The larger purpose of building a budget is downside protection—keeping you out of the poorhouse—but your investments w
ill do that too.
Step 1. Learn from the past. You should start by putting together a record of your past spending, income, and investments. I would go back at least a year to look at the big picture, and three months for a more detailed look at how you’ve spent your money. When you look at the whole year, you don’t have to keep track of everything. Go through your bank statements, tax forms, or pay stubs to add up your income for the past twelve months. Write down how much money you started with and how much you currently have. We’re looking only at liquid assets, so don’t include money you’ve contributed to a retirement account or any other form of investment that you can’t cash out of at no cost with a quick trip to the bank. This should give you a picture of your income and your spending over the past year. To determine your necessary spending, take the amount of money you spend on rent, food, utilities, medical care, your children, and transportation in a month, multiply by twelve, and write that number in the necessary expenses column. For your discretionary expenses, subtract your necessary expenses from your total spending, and that’s the number. Next, if you have any investments, write down their value at the beginning of the year and at the end of the year in the investments column. Then write down the total amount of money you contributed to your investments over the year: anything that you diverted from your income to purchase stocks, invest in a retirement fund, or buy a home, to name just a few potential investments. Subtract the value of your new contributions from the total value of your investments at the end of the twelve-month period you’re looking at, and then subtract the starting value of your investments from that number. The amount you end up with is your investment gain or loss for the year. Having filled out all the columns, you’re looking at a record of your income, investments, and spending for the past year.
We’re mostly going to look at your monthly records, but you want to put an annual record together because it can raise some important red flags. If your spending is greater than your income over the past year, you’ve got a problem. If you’re dipping into your investments to make discretionary purchases and you’re not retired, that’s a problem. If you’re losing money on your investments or you’re not contributing to them at all, you need to change that too. That said, the real work goes on at the monthly level.
The rules are a little different when you put together a monthly record of your income, investments, and spending. For this you need to write down everything. Go through your bank statements and your credit card bills and list every single expenditure for the past month. In your necessary spending include only housing, utilities, debt payments, and children’s expenses. I know you need to eat, but put everything else in the discretionary spending column. You’ll see why we do this in a minute. Handle your investments and your income just as you did when putting together your annual budget. I know all of this recordkeeping is incredibly tedious, but the biggest mistake people make when they start budgeting is trying to put a budget together from scratch. You don’t live in a vacuum, so you can’t just declare that you’re going to spend X amount and save Y amount every month and expect it to work. You already have habits and you need to use the past as a reference point for putting together a workable budget for the future.
Step 2. Judge your past. This is where you figure out how much less money you can realistically spend. We do that by creating an ideal budget. Go online and shop around to determine the least amount of money you can spend on the basics without making yourself miserable. The odds are, whatever this number is, it’s less than what you put in the discretionary spending column of your records, where, if you remember, we included all kinds of necessary purchases. It’s true that food and shampoo are necessary, but what you’re spending on them might not be. You shouldn’t have to live like a pauper, but by creating an ideal budget you can get a good sense of how much more money you could have turned into capital in the past month. The main reason to put this information together is to figure out where you’re spending more than necessary. Break it down by categories too, and then compare your ideal budget to your actual expenses over the past month and the past three months. The difference between the real expense report and the ideal expense report is the maximum amount of money you could have turned into capital in the past and can potentially turn into capital in the future.
Don’t stop there. Remember, we’re creating a long-term budget. You’ll want to annualize the difference between your real expenses and your ideal ones. I bet it adds up to something substantial. Then use a compound interest calculator to figure out how much capital you spent rather than invested over five years, ten years, and thirty years, compounding at 5 percent and then 10 percent. This is what I mean by budgeting for a lifetime. Figure out what your extra spending actually means in terms of future wealth. I’m not suggesting that you eliminate all of your extra expenses, because that would make you miserable. But you should understand their true long-term cost and shift as much of that spending to capital as you can.
Step 3. Create your short-term budget. Use your expense records to create a budget for the future. Take out all the onetime income and the one time expenses from your records, but only if you can honestly say that you really won’t be buying the same things all over again. If you’re already saving more than 20 percent of your consistent after-tax income, then you’re in great shape. You still need to create a budget, but you don’t necessarily need to change your behavior. You’re not in danger of becoming poor anytime soon. For everyone who’s already turning more than a fifth of their income into capital every month, there’s no reason not to keep going.
It’s important to keep your goals reasonable when you put together a budget, but reasonable can mean anything. I think it’s unreasonable to believe that you can invest 20 percent of your income next month if you have been investing none of it. I think if you’re spending money like crazy, it’s unreasonable to expect that you’ll take a vow of poverty. Once you set an unreasonable goal and fail to meet it, the odds are good that you’ll give up. That’s why people who think they’re doing all the right things often end up going broke anyway.
In general, when you plan a budget you want to create as much capital as you possibly can. Capital will make wealth; capital will keep you from going poor. The more of your income you turn into capital, the better your chances of becoming really rich. That’s it. The only place you’re going to find more money to invest when you’re building a budget is in your discretionary spending. So, broadly speaking, your goal is to create and adhere to a plan that has you saving less and investing more, but that doesn’t differ too radically from how you’ve been using your money in the past—unless you really believe you can hold yourself to the new plan, and most people can’t.
There’s really no magic percentage of your income that should go to the non necessities when you put your budget together. A lot of this depends on your income and on how badly you want to build wealth or stay out of the poorhouse. That said, you don’t want to go insane. And you’re not building wealth just so that you can retire comfortably; you want to buy things. My rules of thumb here: you have to be able to go out to dinner or go to the movies at least a couple times a month; if you have a hobby you’re really passionate about, or just want a big TV set, then you have to figure out how you’re going to pay for it over the long term before you buy it. If you make $46,000, which was the median household income in the United States in 2006 (if you took all the households in America and lined them up from the household making the least amount of money to the household making the most amount of money, the median household would be the one that’s right in the middle of that line), then you need to decide if you can afford to buy something with your annual income alone, or if you will have to use some of the money generated by your capital to pay for it. You also have to look at the cost of that product over all the years you’re going to use it, and you need to take a good hard look at what you’re giving up in the future to pay for what you’re buying in the present.
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nbsp; As for building capital, if your goal is financial security, a home, and retirement, then depending on your income, you can probably achieve that by saving 10 percent of your income, even if you make only $40,000 a year your entire life. You can absolutely achieve it if you save and invest 20 percent of your income, especially if you start early. And remember, the more you save early, the less you’ll have to save as you get older, because with time and compound interest on your side, big savings in your 20s and 30s matter a lot more than big savings in your 40s and 50s. Isn’t fate cruel? In your 20s, when you’re young and want to be reckless and irresponsible, that’s when budgeting money to save and invest is most crucial and most valuable. Youth really is wasted on the young! Of course, I believe that we need a little bit of recklessness and irresponsibility now and again, but only as much as we can afford. Luckily for the young, they can also take much bigger risks with their money by speculating on stocks, something I’ll discuss later, and something that’s a whole lot of fun.
I know there are many people, especially the young, who just cannot afford to save money. If you’re barely making ends meet, then it’s possible that you belong to this club. We want to build wealth, but before we can do that we have to keep you from becoming poor. That means you need health and disability insurance before you start to save and invest your money. You need a place to sleep at night. You need to eat. If, after the essentials, you have nothing left for savings, there are a few things you can do. If you’re young and working at an entry-level job where it’s likely you’ll be promoted and paid more in the future, you don’t need to worry. If your job doesn’t offer you many opportunities to make more money, then you need to find a new one. There has to be room in your budget for savings.
Jim Cramer's Stay Mad for Life Page 5