The Basis of Financial Planning
“Where does all of my money go?!” I am sure that you have probably asked yourself this question at various points in your financial life. The answer can be complex, depending on your individual circumstances. The first step in getting control of your expenses is understanding what contributes to your expense profile. Once you understand that, you can start examining those expenses and establishing a plan to reach your goals.
As a financial planner, I often encounter individuals who either don’t have a budget or understand their finances as a whole. Some people don’t want to look for fear of realizing their habits (emotional resistance), some don’t have, or want, to dedicate the effort (time restrictions), and some people make enough that they don’t care (blissful ignorance). In any case, a financial advisor can help guide you through the discovery process as a fiduciary. Working with another person acting as your fiduciary will often enable you to overcome the hurdles.
I would argue that even those households who know they don’t spend more than they bring in as income should establish some basic knowledge of where the money is going. While things have gone or are going well now, they might encounter an unexpected life event, such as a loss of employment, unforeseen medical expenses, or having to provide financial support for aging parents; just to name a few examples. Such events often require very specific attention to finances, and having to navigate the process in the face of such a change can make the process even more daunting.
Small Steps, Broad Categories
Many individuals are intimidated by the scope of their expenses. This is not unlike starting a large project at work, writing an article (!), or tackling a home improvement project. It is best to start with just writing down some of the easiest, known categories. Don’t try to get into all the details at this stage. This is most easily accomplished by thinking about what goes on in your day-to-day life, and using a typical day’s activities to build out categories.
What do you do when you wake up? It might be that you shower and get dressed. You have two categories right there – you use water (Utilities) and you have clothes you obtained at some point (Clothing). Then, you might grab a bite to eat for breakfast (Groceries), lock your front door (Housing) followed by dropping your child off at school (Kids), then a car ride to the office (Auto). You just built a few more broad categories. You go out to eat for lunch (Dining), call your parents (Cell Phone), and get a haircut (Personal Care) after work. Keep an electronic log or write these down and build on them over time.
Once you have had some time to think about these broader expense categories, you can start to think about the type of spending each category (or sub-category) represents. There are expenses that are the same week-in and week-out, or predictable and unchanging on a monthly basis. These we can define as “Fixed.” When they are not always consistent or change each period, we can define these as “Variable.” Each category or subcategory can be classified this way.
Next, evaluate whether the expense type or category is a purchase that is an absolute necessity in your life right now. If the expense is one you elect to make, but don’t necessarily need to purchase - we classify those as “Discretionary” expenses. For those expenses that you feel you require for day -to-day existence, we call those “Non-Discretionary” – meaning, you don’t have much of a choice on whether to spend the money or not on that category. Each of your categories or subcategories will be either Discretionary or Non-Discretionary.
Here are a few examples that might apply to you:
Your broader category list will now have two attributes assigned for each category – Fixed or Variable AND Discretionary or Non-Discretionary. Now, simply use a quadrant assignment for each based on the attributes you assigned. How you classify things will be based on your opinion on expenses; there is no “right” or “wrong” answer for this. Here is an example of what it might look like:
This process will give you a visual on what types of expenses you have. It also shows you where some opportunity to control expenses might exist. The color coding applied here gives some general perspective on what might be first to review and adjust (green), followed in order by those items which are less opportunistic in terms of adjusting (yellow and red).
The next step would be to then start tracking where exactly your dollars are going. Creating a simple column of each category and item you just completed, try to estimate what you think you will, or should, spend on the items. Write that number next to the expense item. Then start tracking what you are spending in each item. Often, those who have done gone through this exercise are surprised with the results; they never realized how much was being spent in each category. Start with just keeping a list nearby and marking down each expense as you incur them alongside the item.
Some people use their monthly credit card statements to assist with the exercise. Over time, you can evolve the tracking of your expenditures into using more sophisticated methods. These might include spreadsheets, apps, and/or auto-downloads from a bank or financial institution. As you progress in the tracking, you can then expand this into setting budgets for expenses and tracking more closely what you spent versus what you forecasted.
What Does All This Get You?
Knowing where and how you spend your money is the key to making changes. You have to know where you are before you can decide where you want to go. Not doing so and making an arbitrary decision to cut back in a certain area usually does not achieve your goal. You might be shocked to realize that you are spending three times as much as you thought on dining out and transfer those savings into other opportunities.
Additionally, getting a handle on your expenses might allow you to fund an emergency reserve for unexpected changes. For single wage earners, the general rule is that you should have six months of expenses in reserve, and half that level for dual wage-earning families. You might also start that savings plan you have been thinking about for years or setting aside some money from your paycheck to fund your retirement.
Before embarking on sweeping changes, it is recommended that you speak with a financial planning expert. Each person’s financial situation is unique and must be appreciated in the context of other variables. The financial advisors at Blue Chip Partners are trained to help guide you in your financial journey.