Poll: Top-Down or Bottom-Up Budgeting?

I was in a discussion about budgeting and eventually decided that there are two primary types of budgeting by households. I called them “bottom-up” and “top-down”. However, there are some differing definitions of these terms floating around, mostly in connection with businesses or governments. So first, some quick definitions:

Bottom-Up Budgeting is focusing on your spending and trying to manage each one. You keep track of your spending, either item-by-item with lists or by category using software like Quicken or Mint.com. You look at each expense somewhat holistically and decide consciously if you need to cut back or if you are happy with the amount being spent. Whatever is left, is put into savings.

Top-Down Budgeting is the simpler, big-picture type of budgeting. You decide how much you want to save from your income, either by percent or total amount. Examples: I want to save 10% of my take-home pay. I want to save $1,000 a month. After you figure how much you want to save, you just try to set that aside, and spend the rest however you like.

Alternatively, you might say “I want to spend $3,000 a month total.” I still consider this top-down budgeting if you are not looking at each expense separately each month. The focus is still basically saving some fixed amount for the future.

Share! Vote in my poll…

What method of budgeting do you prefer?

View Results

Loading ... Loading ...
If you don’t see the poll above, you may be viewing the RSS feed and should click and visit the actual blog website.

Slow Down Your Hedonic Treadmill

You may be familiar with Predictably Irrational, a best-selling book by a professor in behavorial economics that challenges the idea that humans behave rationally. In fact, says author Dan Ariely, humans are predictably irrational in many ways that may surprise you. I recently learned about his new book, The Upside of Irrationality, in this Yahoo article by Laura Rowley, which according to the description “exposes the surprising negative and positive effects irrationality can have on our lives.”

One of the more intriguing topics Ariely explores is the idea of hedonic adaption, also known as the hedonic treadmill. From Wikipedia:

Humans rapidly adapt to their current situation, becoming habituated to the good or the bad. We are more sensitive to our relative status: both that which we recently have and that which we perceive others to enjoy.

When things are awesome, we eventually get used to it (celebrities, lottery winners). When things are really awful, we get used to that as well (severely injured). This is why it’s hard for people to achieve a constantly higher level of happiness. We get a nicer car/house/toy, we get used it, and then soon we just want an even nicer car/house/toy, never getting anywhere as if we are walking on a treadmill.

So how does this relate to money and personal finance?

Stay Happy By Slowing Down Pleasure

Considering that we only experience transient pleasure with many improvements in our lives, we should take care and indulge very gradually. Savor each slight improvement! A good quote from Ariely:

Imagine a new college graduate, finally earning an income and eagerly anticipating a beautifully furnished apartment after years of dorm living. “The lesson here is to slow down pleasure,” Ariely writes. “A new couch may please you for a couple of months, but don’t buy your new television until the thrill of the couch has worn off.”

When Slashing Expenses, Make Big Cuts

On the other hand, we should take full advantage of our adaptability by cutting back as much as possible all at once when we have to. Don’t slow down the pain and drag it out with constant reminders.

“It will be really painful for a few months but you’ll get used to it,” says Ariely. “It might be good to cut down too much — and then increase back.” By contrast, making small lifestyle adjustments every month requires readapting over and over and prolongs the pain. (By the same token, it may be better to reduce a major expense in one fell swoop, such as moving to a smaller apartment, than to face the daily downer of skipping your favorite gourmet coffee, Ariely suggests.)

I think the apartment idea is very good application of this theory, and look forward to reading the rest of this book.

Blippy.com: Are You What You Buy?

While flipping through old magazines at the Doc’s office, I read about a site called Blippy.com in a Time article. It’s yet another social media site, except this time you link up your credit card data so it can automatically share all your purchases with others (amount, store, and in limited cases actual items). You can add more details, and users can comment and discuss each others purchases.

The writer initially thought that such exposure would help control her spending (I call this the “shame” theory). Perhaps you really do eat out too much. However, many users of the site have found that instead people start actually buying items just so they could show up on Blippy. Want to look outdoorsy? Better buy some camping gear at Sports Authority.

Which made me wonder… Are you what you buy? My gut reaction is that the idea just sounds horrible. Does this really paint anywhere near a complete picture of yourself? Maybe it’s actually more objectively accurate than I think. I then thought maybe you are what you don’t buy… but that probably won’t work either. I wonder what people would think of my purchases. I can’t see myself signing up for this.

Still… Twitter is huge, and I’ve only just started trying to use @mymoneyblog regularly. Blippy has been called the “Twitter of Personal Finance”, and one of the co-founders of Twitter is a major investor. What do you think?

Would you be intersted in signing up at Blippy.com?

View Results

Loading ... Loading ...

Calculating Our Personal Savings Rate

Do you know what your household’s savings rate is? Most of us probably have a rough guess, but I wanted to use some more reliable data. Here’s the definition again for my purposes:

Current Spending

There are plenty of ways of tracking your expenditures, as anyone who has tried to follow a monthly budget has found out:

  • Handwritten expense lists
  • Excel or other spreadsheets
  • Online budgeting tools
  • PDA/Smartphone input tools
  • Automated account aggregation tools

I’ve tried various methods to track my expenses manually, but never had the commitment to follow through for more than a month or two at a time. I track all of my numerous financial accounts using account aggregation site Yodlee, but since August 2009 I have linked my primary checking accounts and the few often-used credit cards at the similar-but-nicer Mint.com.

It took a lot of manually categorizing individual transactions, but now it takes less than 10 minutes every couple of weeks at Mint to correct the few new stores I visit (mostly small restaurants). This means I almost have an entire year of spending data from August 2009 to May 2010:

As you can see, there was a general trend, but a few months had major spikes. December had holiday gifts, some travel, and end-of-year charitable giving. In April, we bought a new high-efficiency washer/dryer and had some home electrical-repair bills. In May, we bought our plane tickets and hotel accommodations for a trip to Peru. The lesson here is that there are always going to be these spikes, and it’s best to be prepared and account for them. Our actual average spending ended up being higher than I would have guessed. The monthly fluctuations ranged from 20% below average in October to 30% above average in December.

Current Income

We are a dual-income couple with no kids currently. Our “big-picture budget” is to be able to live off the lesser of our two incomes. We each make relatively good money, so we have been lucky to be able to do this for a few years now. On a practical basis, we do this by having one primary joint checking account in which we only direct deposit that one paycheck. All bills are paid out of this account. This way it psychologically easier to “live within the means” of that single paycheck as the balance goes up and down.

Current Savings Rate

I don’t reveal actual income numbers, so it’s easier to share the savings rate. I am using after-tax income because I feel it is more applicable. According to the above data, on average we spend 84% of the single after-tax paycheck each year, giving us a saving rate of 16%. This is helpful to know we have a buffer if one of us were to lose our jobs. (We also max out the pre-tax 401k plan employee contributions at our jobs, so the single paycheck is already reduce a bit.) When both of our incomes are included, our saving rate is over 60%.

You may consider this low or high, but in terms of early retirement for most people you’ll need to put away a lot more than the 10 to 15% recommended by some experts. I like the idea of both spending a year’s worth of income and saving a year’s worth of income, although this will not be realistic for everyone.

National Personal Savings Rate Definitions: NIPA vs. FoFA

In looking up some stats for personal savings rates, I found that the Bureau of Economic Analysis (BEA) provides a chart of two separate calculations that track the personal savings rates of US taxpayers:

  1. The National Income and Product Accounts (NIPAs) method, and
  2. The Flow of Funds Accounts (FFAs) method

You may find either of these quoted in mainstream media articles whenever there is a big shift or one goes negative temporarily. Both methods have been criticized for the accuracy, in which I won’t go into detail here. The main differences between the NIPA and FoFA methods are outlined in this chart from the AARP paper [pdf] “The Declining Personal Saving Rate: Is There Cause for Alarm?”:

A few things to note:

  • When I read “disposable income”, I normally think of what’s left over after paying for food and shelter. In this case, disposable income is just personal income minus “personal contributions to social insurance and personal taxes”.
  • Both NIPA and FoFA exclude capital gains on investments, which some say contributes to a “wealth effect” where people will spend more because they feel richer due to growth of investments. (not as much recently…)
  • From the chart, FoFA includes the purchase of new assets and investments as personal savings. NIPA includes employee 401(k) and pension contributions as wage income.
  • FoFA treats the purchase of consumer durables (cars, major appliances) as a form of savings, while NIPA treats it as consumption.
  • NIPA says that paying your mortgage (owner-occupied housing) is savings as imputed rent, while FoFA counts your added home equity as an asset, but your mortgage payment as a liability.

Confused yet? Well, I hope at least you came away with something. The AARP paper goes on to explore various theories for the long-term decline of the personal savings rate. If you’re looking for more, here’s another paper that explores the differences.

Beyond Net Worth: Tracking Financial Progress Better

For a while now, I’ve been thinking about a better way to publicly track my progress towards financial freedom and also allow easier comparisons between readers. I’m sure some people would miss the net worth updates, but I have reached the point where our net worth fluctuates mainly with stock market valuations and not due to actual improvements to income or savings rates.

First, I started to brainstorm the required data needed for such tracking, each of which I can address in a future post. Once we collect these numbers, I can then put out some numbers and ratios that could be better indicators than plain net worth. Heck, a portfolio of a million dollars is nothing if you plan on spending $100k a year, but if you only spend $40k a year and have a small pension, you could be all set.

  1. Current Monthly Income (After-Tax)
    How much money are you taking in right now? For those with variable paychecks, it would probably be best to average this out over the trailing 12-months or 6-months.
  2. Current Monthly Spending Rate
    How much are you spending? This should also be averaged out over at least 6 months, in order to capture all those irregular bills like my semi-annual car insurance bill, as well as those unexpected expenses that always pop up. For example, in the last few months alone we have had an $1,000 electrician bill and a $500 auto repair tab.
  3. Current Portfolio Size
    How big is your current investment nest egg? If you include your house, then you’ll need to include the cost of renting in your future spending.
  4. Future Spending Rate
    What is your “burn rate” going to be in retirement or semi-retirement? Many online calculators simply assume this is 85% to 100% of your current monthly spending. This can be too generic. For example, in less than 20 years, I plan to have my house paid off. My mortgage is more than 50% of my current expenses! Other items like health insurance premiums will be harder to predict.
  5. Investment Return
    There are many smart folks making educated guesses about future market returns based on both looking backwards and forward. Based on your chosen asset allocation, one can at least attempt a rough estimate of future after-inflation returns. We can’t rely on these numbers, but it’s a good beginning.
  6. Safe Withdrawal Rate / Retirement Income Rate
    How will you create your income during retirement? If it’s going to be from selling stocks or bonds, you’ll have to decide on how much is okay to withdraw each year so that you don’t run out. Will you draw a fixed percentage each year? Adjust annually for inflation? Adjust annually for market returns?

    What if you are planning to live off dividends or bond income? What if these fluctuate? If you have a pension or annuity, how will this fixed income change how you draw down other assets?

Potential Indicators

A simple example would be calculating your personal savings rate, which would be independent of market fluctuations for most people:

Multiply by 100 for a percentage. Hopefully this isn’t negative! Another good ratio might be your portfolio multiplier factor, which tracks how big your portfolio is relative to your planned future spending.

Depending on who you talk to, a Portfolio Size Factor of 25 to 35 might be desirable if you are withdrawing money from a portfolio of 60% stocks and 40% bonds. Adjustments should be made for pre-tax vs. post-tax accounts.

I could post these and other monthly indicators each month, instead of net worth. What do you think? Any other numbers that I’m missing?

Bundle.com: Compare Spending Patterns With Similar Folks

I’ve been catching up on my stack of old magazines, and in the process discovering a bunch of new websites. One appropriate site to mention is Bundle.com, which describes itself as the “first money comparison site that lets you see how people just like you spend and save money.” Here’s a promotional video from them which walks you through it:

For example, this is what the households in San Francisco, CA were spending their money on in December 2009:

“House & Home” does not include mortgage or rent, but are things like utilities, home repair and improvements, and phone service. “Health & Home” includes insurance, child care, pet care, and charitable giving. Where does the data come from? Via their FAQ:

With a team of experienced statisticians and data junkies, we’ve compiled, tagged and sorted data from a (still-expanding) collection of sources. Our data comes from the U.S. government, from anonymous and aggregated spending transactions from Citi, and from third party data providers.

Aha, my sneaky Citibank card! This is exactly the kind of data I would think would be recorded and sold from aggregation sites like Mint.com. Now, is it just me, or is there no data available under the “Saving” tab?

April 2010 Spending Snapshot

I’ve been trying to track our expenses better using Mint.com, which means combing through transactions and manually correcting many of the automatic categorizations. I think it’s working, at least in that I hate doing it so much that didn’t make a purchase today so I wouldn’t have to categorize it later. :)

I found the home page chart greeting me today amusing:

We did pretty good this month, but it would seem like all we do is eat and drive (and in the case of fast food, probably both at the same time). I notice that housing and utilities aren’t included, but I’m not going to tweak the targets until I have a couple months of spending data first.

Mint.com Wants Limited Power of Attorney

A reader recently asked me about what I thought about the fact that financial aggregation site Mint requires you to give them limited Power of Attorney when using their website. There was also a recent discussion on Bogleheads about it. You can find it in the Terms of Use Agreement page.

For purposes of this Agreement and solely to provide the Account Information to you as part of the Service, you grant Intuit a limited power of attorney, and appoint Intuit as your attorney-in-fact and agent, to access third party sites, retrieve and use your information with the full power and authority to do and perform each thing necessary in connection with such activities, as you could do in person. YOU ACKNOWLEDGE AND AGREE THAT WHEN INTUIT IS ACCESSING AND RETRIEVING ACCOUNT INFORMATION FROM THIRD PARTY SITES, INTUIT IS ACTING AS YOUR AGENT, AND NOT AS THE AGENT OF OR ON BEHALF OF THE THIRD PARTY. You understand and agree that the Service is not sponsored or endorsed by any third parties accessible through the Service.

Sounds serious! My first thought is that without this clause, Mint could not perform their intended service of being a one-stop shop for all of your online financial accounts. They would essentially have to walk up to every single site and ask for permission to be an official portal for them, yet at the same time be released from liability. That would be basically impossible.

In the end, you are giving up some of your rights in exchange for the convenience of having all your accounts checked for you at once. If you are worried about something going wrong with either Mint, a rogue employee, or a malicious hacker getting access to your personal information, then you might consider limiting what accounts you link.

Along that line, I would think that credit cards would be both the most helpful to link since you can then track your expenses, while also having the least exposure to fraud. This is because as long as you report any fishy behavior to your credit card issuers as soon as you find it, you likely won’t be liable for any unauthorized charges. (And if you monitor regularly with Mint, you’ll be that much more likely to notice…)

However, I for example would be more hesitant to link my Vanguard and Fidelity accounts with the bulk of my IRAs and brokerage accounts, as the benefits aren’t as great. Most of my net worth is stored at those brokers, and any screw-up would be highly stressful. Besides, I can usually check my balances at those sites separately with little added effort.

What do you think?

15-Minute Resolution #4: Automate Your Emergency Fund

It’s Friday, so here’s an easy slam dunk resolution involving emergency funds. If you’ve done any sort of financial reading lately, you know that many folks recommend having at least 3-6 months of living expenses put aside. Given the current high unemployment rates, I personally wasn’t comfortable until I had 12 months of expenses. Not only could you lose your job, but there could be unexpected health expenses, car repairs, or whatever. But that’s not the main point here.

The easiest way to build your emergency fund is to put it on auto-pilot. Your task for today is to schedule an automatic, repeating monthly transfer of $100 into a savings account.

Just about every savings account available allows you to set up an automatic monthly transfer from your checking account. Here is how to do it with Capital One 360′s Automatic Savings Plan. I just chose $100 as a round number, but change it as you like.

(Perhaps you’ve already got a healthy emergency fund. If so, then you can apply this resolution to another specific savings goal, like a new car fund or in our case a pet healthcare fund to replace costly pet insurance.)

Instead of telling you more reasons to do it, I’m going to try to counter any reasons NOT to do it.

  • Don’t wait until tomorrow. It won’t get any easier later on, only harder.
  • Don’t open up a new account, if you already have one available. If you don’t, one of the fastest applications I’ve seen online is at Capital One 360. Takes less than five minutes.
  • Don’t worry about interest rates. It doesn’t matter if your savings account doesn’t earn as much interest as some of the top accounts. This can all be changed later.
  • Don’t worry about not being able to keep it up. Start with as much or as little as you feel comfortable. It doesn’t matter if it’s $100 or $1,000. I don’t even care if it’s $10.

The hardest part is starting. You can always change your mind later, it’s still your money. But hopefully, in several months you’ll wake up to a big chunk of money you didn’t even realize you saved.

See the rest of my 2010 Instant New Year’s Resolutions here!

Relationships and Money: Are You Communist, Socialist, or Capitalist?

I was catching up on some blog reading and caught an old post from Plonkee about the different ways that couples can manage their finances. The three different methods were categorized as communist, socialist, or capitalist. Rather controversial, eh? Don’t get too excited folks, just read on:

Communist: One Big Pot

According to Wikipedia, communism is a social structure in which classes are abolished and property is commonly controlled. Thus, no matter what each person earns, all their income is deposited into one central joint account, from which all expenses are paid from as well. All assets including property, investments, and cash are owned together.

Socialist: Earn More, Pay More

Under this structure, common shared expenses such as rent and utilities are paid via a joint account. Let’s say one person makes $75k and the other person makes $25k. Then if the monthly shared expenses are $1,000 per month, they would pay $750 and $250 respectively. The contribution is proportional to income.

Separate expenses such as entertainment, gifts, or clothing are paid for out of personal accounts. This allows each person to retain some individual control of their money.

Capitalist: You Pay Yours, and I’ll Pay Mine

Finally, we have the option where purely shared expenses are simply split straight down the middle. Differing income levels don’t change anything; If you make more then you keep more. Everything else is paid directly by each individual. Theoretically, each person is thus incentivized to keep their own expenses down, as nobody else helps to pay for it. There is “my money” and “your money”. This is often how platonic roommates manage their finances.

Just Call Me Karl
Although I usually don’t align myself as communist, I must admit that that is mostly how we manage our money as a married couple. It’s also helpful that we both work and earn comparable incomes (a least for now). We do add in a small “adult allowance” fund where we can spend money on whatever with no questions asked. Besides that, while we definitely don’t always agree on things, I think the combination of open communication and the passage of time has gotten us relatively comfortable with the “one pot” setup.

Now, I don’t think any one type is necessary better than the other, and know couples of each persuasion. I do have one question for the capitalist-types, though: What about retirement? Do you split that too? What happens if one person doesn’t invest adequately in retirement?

Ask The Readers: Favorite Personal Finance Apps for iPhone & iPod Touch?

No, I didn’t get an iPhone. But I did get an iPod Touch over Thanksgiving weekend. (Hurray for Amazon matching Apple Store Black Friday prices!) I know, I know, as a financial blogger I’m supposed to shun such trendy toys, but it was a gift! My parents got one for my sister as well as themselves, and I am assigned to teach them how to use it when I visit in December.

(I’m excited because my HTC TouchPro2 with my $30 Sprint SERO can be hacked to share it’s 3G connection as a WiFi Router, so I can get my iTouch online anywhere I have cell coverage. Nearly an iPhone!)

Another perk is that now I can review all those personal finance apps out there. I know there are a lot of budgeting apps, the Mint.com app, and various ones for banks and brokerage companies.

What are your favorite apps? Which ones were worth the money, and which ones weren’t? Which free and non-free apps would you like me to review? Share in the comments below.