This post has been cited by the 215th edition of the Carnival of Personal Finance, hosted by Good Financial Cents.
This is the second in a series of posts on investment planning. For those who haven’t read the first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts in the series:
- Investment Planning: The Series
- Household Budgeting the Easy Way [this post]
- Budget Tracking and Projections (with Quicken Tricks)
- Willingness, Ability, and Need
- Estimating a Retirement Budget
- Need for Risk: The Details
- Multi-Period Planning and Asset Allocation
- Investment Planning: Reader Tips, Tricks, and Links
The internet and book stores are loaded with advice on creating a household or family budget. There are two fundamental approaches: proscriptive (or normative) and descriptive (or positive). A proscriptive budget is one that conveys how you ought to allocate your money. Someone in debt or struggling to live within his means would benefit from a proscriptive budget the following of which would deliver him to a debt free life.
Since I do not have a problem with debt or living within my means I do not have much need for a proscriptive budget. On the other hand, a descriptive budget that illustrates with reasonable accuracy how my household finances are allocated to investments and consumption is very handy. As I will show in subsequent posts in this series, a descriptive budget is the basis for investment planning. In the remainder of this post I provide an easy way to construct a descriptive budget.
One can find many web pages and books devoted to descriptive budgeting. What I don’t like about most of them is the suggestion of the need for great detail. How much do you spend on food? On clothes? On gas? On entertainment? And so forth. For me, and I suspect many others, a budget at this level of detail is not necessary or helpful. (It is necessary and helpful for proscriptive budgeting or for the very frugal or intensely curious.)
Since my goal is an easy, high level (but accurate) descriptive budget, I take as a starting point that I spend the “right” amounts on each of the subcategories listed above (food, clothes, gas, entertainment, and so on). Therefore, a simple way to build a descriptive budget is to base it on the lumpy institutional structure that underlies one’s actual cash-flow: paychecks and bills.
This is easy. Take out a representative and recent set of paychecks and bills or go online and download them. Write down values for average payments (as illustrated in this spreadsheet). To make things simple, when entering your paycheck amount, use the amount you receive net of all deductions (e.g., for state and federal taxes, health, disability, life insurance, 401(k) contributions, and so on). This works fine if you’ve set your tax withholding properly (see IRS withholding calculator). Also, notice that this document-based approach has you entering in your budget a representative amount for your credit card bills but does not drill down into the bills to allocate payments by type (food, gas, clothes, etc.). As already mentioned, that detail is not necessary for this type of budget.
This approach is particularly easy if your payments do not vary much. In my case this is true for most bills because either they just don’t vary (e.g. mortgage, life insurance, internet, cable, and others) or because I’ve set up “budget payments.” A budget payment option is often available from utility companies: each utility estimates a yearly amount and you pay an average monthly value independent of your use. Then you settle up at the end of the year. After an adjustment period, the estimates get more accurate and the settling up is a small transaction that can be ignored in the budget.
The biggest variation for me is in my credit card bills. Nevertheless, upon examining a representative set (6-12 months worth, say), I have found it possible to settle on a reasonable average figure. In following this approach it is important to omit or adjust payments for months of credit card bills corresponding to unusual, one-time, enormous payments not reflective of usual spending habits (e.g. a huge payment for wedding catering).
The accompanying spreadsheet includes the list of items in my budget with fictional but representative figures and frequencies. Your list may differ. If you spend a lot of cash or make many check or debit purchases you may need entries to account for those sources of expenditure. Since I pay almost everything by credit card, I don’t have such a line. Be sure to prorate everything to the month (or year or week if you like) and total it. If the total is less than zero then you have negative cash flow and you may need a proscriptive budget get back on track. I will assume you have positive cash flow in this positive (descriptive) budget. The total line represents what you have left to spend on more stuff or to save/invest (though, recall, 401(k) investments are included in our net paycheck). In subsequent posts I will call this (assumed positive) total amount the surplus.
That’s it. We’re done. Was that hard? I don’t think so. Yet, we now have a budget that is perfectly adequate for a variety of investment planning purposes. Greater detail is not necessary. But if you want greater detail, it will not hurt to have it. It will just take you more time to construct such a budget and to use it for tracking. I will explain that concept and put our budgets to work in the next post.
