5 Practical Budgeting Principles

Creating and managing a personal budget is not high on anyone’s fun pastimes.  If investing and saving are like throwing a party – exciting, filled with good times and hopefully positive outcomes, then budgeting is like the morning after clean-up.  You know it must be done.  You know you’re going to find some unpleasant items.  It’s likely you’ll question some of your life choices. Perhaps you’ll need to burn some things and start over.  Hopefully not that last one.  I’ve learned some practical budgeting principles that can at least make it more tolerable.

I’m not saying these principles will make the process fun.  However, I believe they can be utilized to help make the process useful.  Taking control of personal money flows is foundational to understanding whether your goals are achievable within your desired timeframe.  Life is full of choices and trade-off decisions.  Having the right approach and accurate information can make the difference between being successful and being frustrated. 

1. Income – Costs = Your Plan

At the most foundational level, a budget describes the sources, timing and amounts of inflowing money less the sources, timing and amounts of outflowing money.  That’s it.  The principle is easy enough to understand. However, it requires some discipline and resolve to put a useful budget into place.  Historically, personal budgeting meant balancing our checkbook.  As long as there was a positive balance, checks could be written for expenses as they occurred.  We write fewer checks today. Most families have financial pictures that are more complicated and can not be reasonably represented in a single checkbook.  But the principle is close to the same. While balancing a checkbook enables a point-in-time snapshot for a particular account, it doesn’t enable solid future planning. 

It’s certainly important to know whether we have enough funds to cover a current bill or impending expenditure.  However, we still won’t be able to easily see the big picture nor understand how individual transactions fit into our overall plan.  Without this ability, decision making becomes difficult.  Most money decisions don’t require extensive analysis.  However, we should make larger choices in the context of how they will impact our financial plan.

Opportunity Cost

At this point, let’s remind ourselves of the notion of opportunity cost.  In economics, opportunity cost is the result of choosing one alternative over another.  For example, let’s say we choose to spend $30,000 on a new car.  We will then forego using that money for some other purpose.  The money used to purchase the car can’t also be used to replace our roof, saved in an education account, or leveraged to pay down a debt.  A budget helps put bigger decisions in context of our overall plan.  We can consider the alternative uses for big money decisions and ensure we’re comfortable with the opportunity costs of those decisions.

2. Show Yourself the Money

One of the most famous move lines of all time is when Tom Cruise’s character, Jerry Maguire, in response to his client’s urging, yells “Show me the money!”.  Although it might be fun to scream this at our computer, we probably don’t need to be quite this dramatic.  Attaining and maintaining visibility into the sources, timing and amounts of incoming and outgoing money is what enables personal budgeting to happen.  We have choices in terms of how to do this  Should we create our own spreadsheet, or should we use a professional budgeting app?  And, if we elect to utilize a professional app, which one best serves our needs?

Spreadsheet Option

My preference has been to maintain my own spreadsheet.  For me, the benefits of this option outweigh the drawbacks.

Benefits

• We enable a full personal financial picture to be created in one place (budget, savings charts, asset balances, etc.) – and spreadsheets can be tailored to meet my specific needs.
• We reckon with the data – seeing and touching the data every month so three is a lower chance of glossing over the information or missing changes in spending patterns.
• And, we don’t have to provide personal financial information to a third party – most of today’s apps have very strong security/encryption capabilities…but this may still be a concern for some.

Drawbacks

• Spreadsheets can be tedious to maintain – despite being able to import data from most places, it still must be brought into our preferred format and potentially reformatted each month.  This is a chief reason people abandon managing a personal budget.
• We miss out on professional budgeting tips, strategies and tools – these could be important factors for new budgeteers or those struggling to get a handle on spending.

Simple Spreadsheet Template

The embedded spreadsheet template will enable you to start putting these budgeting principles into practice. It’s a variation on the standard Excel personal budgeting template. However, I’ve added a worksheet where expense details can be added. The summary worksheet has been set up to show budget performance across a full year.

App Option

I won’t repeat the potential benefit and drawback summary as it is the inverse of the spreadsheet option described above.  Investopedia has a nice comparison of budgeting apps as of 2022.  All of them offer a free trial period.  All of them offer secure, encrypted connections.  Some of them are free to use.  The top paid option is “You Need a Budget” (YNAB) while Mint is the pick for the best free app.  You will still link your financial institutions and accounts so that your data can be utilized by the budgeting app. Keep this in mind when deciding which way to go.  Going this route is absolutely legitimate and appropriate for many people.  Technology has made it possible to bring data together automatically and safely and present it in ways that greatly aid the budgeting process.         

Data accuracy and completeness are critical no matter which option is selected.  Omitting sources of income or spending can be nearly as dangerous as not having a budget at all – particularly on the spending side.  We should not forget about expenditures that happen only on an annual basis.  Taxes and certain subscriptions or dues are chief examples.  Charitable giving also falls into a category of spending that we might not remember to include at first pass.  If we’re unwilling to show ourselves all the money, we’re not going to have a worthwhile plan.  

3. Focus on the Right Stuff

The Pareto Principle (named for Vilfredo Pareto who was an Italian economist, sociologist, and engineer) states that 80% of outcomes or consequences come from just 20% of the causes or choices.  This is an observation and not an absolute. However, it reminds us that everything is not equally weighted in life.  For our budgeting purposes, we might apply this principle to the way in which we categorize and analyze sources of spending.  Fixating on individual expenditures will not likely be productive.  It might only result in some vague but worrisome feeling every time we go to a coffee shop or grab lunch with a friend. 

Aggregate spending into categories that are used to set goals and track progress against them.  Eliminating our consumption of Grande lattes and avocado toast is unlikely to move the needle on achieving our big life objectives.  If it does, we probably have other problems to address.

Top-Down Budgeting

When we establish objectives within an overall plan, we can then establish goals and actions that support those objectives.  For example, let’s say one of our main life plan objectives is to purchase a house in an area our family wants to call home.  Our budget will need to accommodate: (1) the upfront money required for a down payment and closing costs and (2) the money required for ongoing support of the house (mortgage, property tax, homeowners’ insurance, furnishings, maintenance, HOA fees, utilities, improvements).  Characterizing these expenditures will allow us to make “room” in our budget.  Making that “room” from our “Dining out/Entertainment” category or by paying off, and therefore eliminating, our “Car Payment” category is up to us.  Likely we’ll need to actively adjust spending across multiple categories to accommodate something as big as buying a new house. 

Perhaps we’re able to incorporate a new source of income.  Whatever the case, our monthly budget will be a key tool in making it all work.

The important thing for us to establish is what our current income less spending picture looks like as opposed to what we need it to look like in support of our life objectives.  Once we have the overall picture in place, it is possible and necessary to break it down into realistic categories so that we can establish monthly goals and change our behaviors, as necessary, to match those goals.  Budgeting is simply a tool to help align what we do with what we believe we want to do.  How we break our spending down into manageable categories matters less than whether we remain honest about assessing actual spending against our goals across whatever categories we identify.

Don’t Forget about Debt

Borrowing money is an important financial tool.  Most of us will need to leverage this tool at various points during our lifetime in support of key life goals.  Borrowing gives us near-term access to capital that wouldn’t otherwise be available to us.  It provides flexibility and a means to an end. But just as misusing physical tools can be dangerous, so too can be misusing the tool of borrowing money.  We should strongly consider the early repayment of debt as part of our financial objectives and monthly budget.

In a previous post where I lay out some things to consider before investing in the stock market, I briefly describe the risk inflation poses to long-term financial goals.  Debt such as from credit cards or auto loans can pose an even more serious threat to those goals.  We can include and prioritize the early repayment of borrowed money as a key budget category.  This category of spending likely falls into the most important 20% of the things we ought to be concerned about.

4. Prepare for Surprises

Of all the practical budgeting principles, this may be the most emotionally taxing. We don’t like to consider what might go wrong. What might cause our plans for the future to be derailed.

Insurance is a category of spending essentially all of us will need to include in our budget.  Insurance takes many forms (health, auto, home, life) but it’s necessary in today’s modern world.  Companies like State Farm, Geico and Progressive don’t have expensive ads plastered all over the airwaves and internet because nobody buys their products. As it relates to the  idea of an opportunity cost, all of us would surely love to be able to spend money earmarked for insurance on something else.  However, insurance helps to protect us from surprises that might otherwise be catastrophic to our plans.  In a similar way, keeping some money in reserve to deal with surprises is a good idea.

The best laid plans won’t prevent surprises from happening.  Our choice, then, is either to deal with surprises that happen when they happen, or to reasonably prepare for some amount of surprise.  Not everyone will have the ability to set aside money in preparation for events that may or may not come.  Borrowing money, whether through the use of credit cards or short-term loans, might be the only realistic tool in such circumstances.  Thankfully, most of us will have some form of this tool available to us.  But what if we do have the capability to establish and restore an emergency balance – how much should we try to keep?  What amount of “surprise insurance” should we target?

Scenario Planning

We may have heard the heuristic that we should target keeping six months’ worth of salary in reserve for emergencies.  Holy moly!  This is likely a daunting sum and, as is the case with most heuristics, it may not be the right sum in particular cases.  What if we instead engaged in scenario planning to determine a more realistic number that relates to our specific circumstances?  Scenario planning is the practice of modeling possible future outcomes based on reasonable assumptions and ranges of information. 

Revisiting Signore Pareto’s principle, what if we focused on the most impactful 20% of potential surprises we can conceive of?  With a little research and application of assumptions based on what we already know, we should be able to develop a portion of our plan and budget that acknowledges important unplanned events.  Whether or not we can immediately fund our “surprise insurance” policy is not as crucial as considering how we’ll deal with surprises along the way.  We will all eventually be surprised.  How we will deal with surprises should be part of a plan we have in place.

5. Plan-Do-Check-Act (PDCA)

I don’t believe in having a “Plan B”.  There should only be the one plan.  We may need to be rethink, adjust or even fully recreate the plan.  Tools like Scenario Planning and Monte Carlo simulation can help us to identify risks, remedies and alternative paths. We still need to work within a plan we want to see come to fruition.  If you’ve read my planning model post, you’ll recognize Plan-Do-Check-Act as a simple model to help enable successful planning.  Checking the budget at a cadence that works for us is a natural fit into the model.  We seek to understand what has gone according to our budget, what surprises we’ve experienced and whether we feel any changes need to be acted upon moving forward. 

It’s this last part of the model (“Act or Adjust”) that can be tricky. Once we have a monthly budget in place, we can look at income and spending trends over time.  Adjusting our plan based on the results of a single month might not be the right thing to do.  On average, how has our monthly budget performed over the last quarter or two?  Do we recognize any seasonal trends?  We need to balance the desire to adjust our plan based on the most up-to-date information with the principles of averages and seasonality.

Don’t Avoid the Party Because of the Clean Up

By now, we are all ready to fully embrace personal budgeting as the highlight of our month. The very pinnacle use of leisure time and frivolity!  Not so much?  Perhaps we can at least regard creating and managing a budget as a necessary part of the process required to achieve our life objectives.  Budgeting principles help us maintain the proper perspective. Keep the big picture in mind and don’t get bogged down in every piece of information.  It really will be ok if you enjoy a latte tomorrow or lunch with your friend next week.  The best part is that because you have a budget and you see the money big picture, you’ll know why its OK!

Written by: A. Reed Reviewed by: B. Holman