Parable of the Monk and the Minister
Two close boyhood friends grow up and go their separate ways.
One becomes a humble monk, the other a rich and powerful minister to the king.
Years later they meet up again.
As they catch up, the minister (in his fine robes) takes pity on the thin, shabby monk.
Seeking to help, he says: “You know, if you could learn to cater to the king you wouldn’t have to live on rice and beans.”
To which the monk replies: “If you could learn to live on rice and beans you wouldn’t have to cater to the king!”
As mentioned in our 2 years to 2X your Income post, income and spending are the 2 areas of your finances you can have most effect on. Whereas income is not solely dependent on you, your expenses are under your control. Taking control of your expenses can lead to improvement in every other area of your money. Controlling your expenses allows you build savings and savings are power. If you want to travel, take some time off work, buy a home, change jobs, whatever, having a chunk of cash saved gives you the power the follow your dreams.
The default for most people is to spend exactly what they earn. Some a little bit less, some a little more, but mostly spending is tightly linked to earnings. This default position is the main trap keeping people living at the same level for years on end. This is why people don’t have an emergency fund, savings, pensions, or even simply options to choose how they go about many aspects of their lives.
If you can break this ingrained idea you can break the mould. Spending does not have to be linked to earnings and if you want to improve your financial standing, it cannot be linked to it.
You need to separate and fully delink what you spend and what you earn so you are about to develop a surplus of funds to achieve your goals.
“Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.” Charles Dickens.
As long as your expenses are lower than your earnings, you’re on the right track. If you don’t even have a minor surplus, you need to take measures to sort this out. Spending more than you earn is a quick path to misery as debt builds more debt and stress builds. Depending on the level of over-spending you may have to cut more viciously. If you are spending a small amount over your earnings, you might need to cut back on spending slightly and you’re okay again. However, if your spending is massively over your earnings, you should start tracking all of your expenses and start cutting things out like a maniac!
A handy tool for figuring out your level of financial badassity is too calculate your savings rate. This is how much you save as a percentage of your take home pay.
If you have €2,000 in take home pay and you save €500 you have a savings rate of 25%.
Savings rate is a great tool as it shows you what you’re keeping compared to your expenses. This is such an important concept because it is about your expenses and not your income. Try not to focus too much on the euro number amounts in the examples to follow as they’re just a guide to understand the concept. The reason you shouldn’t focus too much on the number amount is because some people will earn €20k per year and some will earn €120k per year. If you focus on the percentages, you know how you are doing compared to your own income. The more you can increase your savings rate, the better off you get as your expenses lower compared to your own income.
Sarah starts working after college and has a take home pay of €1,500 per month. Her spending is €1,400. She saves €100 a month (or 6.7%) and it will take her 14 months to save one month’s worth of expenses. She wants to save more so she budgets and cuts out some spending that’s not aligned with her values and lowers her spending to €1,000. She knows that she can’t lower her expenses anymore without lowering her quality of life so she pats herself on the back and continues at this level of spending. She saves €500 a month (or 33%) and will have one month’s worth of expenses every 2 months. This gives her 6 months of expenses at the end of the first year of increases savings. Not bad at all.
Here comes the real trick. When Sarah changes job into a higher-level position in another company she gets a raise that gives €2,500 per month after tax. As she’s learned the value of controlling her expenses she doesn’t automatically spend more. Sarah knows she is comfortable living on €1,000 per month and chooses to continue living the same lifestyle. She now saves €1,500 per month (150% of her monthly expenses) and knows that if she keeps working for another year while living like this she’ll have 18 months of expenses banked and then she could theoretically not work for 18 months and continue living at the same standard of living. With this amount of savings, she can stop working to travel for a few months and not be worried about money.
At some point most people will hit a spending floor where lowering expenses any further will lower their standard of living past the level they are comfortable with. This is the point you want to get to. Where you are living a lifestyle you enjoy and are comfortable with, but are still saving at a good rate. For some people this is 20% of their earnings, for others it may be 80%.
Just as most people will automatically spend what they earn, most will increase their spending anytime they increase their income.
By not increasing your spending with income, you give yourself increased room to raise your savings rate with ease. This is how you can simply delink your earnings from your spending.
There are different periods of your life where savings rate will differ. If you are savings for something like a house, wedding or a big trip you will of course increase your savings rate. If you have just had a child or lost your job, this will lower your savings rate. However, having your savings in place from easier times will give you the buffer and comfort level you need to take these tougher times in your stride. By lowering your expenses in general, you give yourself a level of badassity and confidence that most people won’t have.
Controlling your expenses is the best way to get your finances under your control as you are responsible for it.
Unlike your earnings, taxes, your field of work, the economy, and investment returns, you are in charge of your expenses. Once you get past the minimum level of comfort you need (which is probably a lot lower than you first think) all of your spending is up to you.
At some point you may choose to increase your spending, but it will be a choice. By starting from a position of low expenses you give yourself the freedom from money worries others will never have.
Check out part 2 of the spending series to learn 5 tips to lower your expenses.
An emergency fund is the first step to wealth. It is difficult and can be impossible to achieve any measure of wealth without the financial and mental ability to shrug off unplanned expenses and minor emergencies.
An emergency fund is a lump of money set aside for unplanned expenses. If you were to have an unplanned expense or minor emergency you would not need to borrow or sell something to be able to pay for it. In a 2013 study by the US Fed 47% of people said that they would have to borrow or sell something to cover an unplanned expense of $400. Building even a small emergency fund can massively lower your stress by removing this instability from your life.
The likelihood of certain risks and the cost that come with them are quite personal, but it is best to think about what are the most likely unplanned expenses to occur for you and then to put a cost on them.
Example of how someone would set their emergency fund:
Broken washing machine – replacement €320
Emergency car repair - €500
Lose your job – 2 months expenses while getting a new job €2,600
In this case, someone with a high risk tolerance might say ‘I believe I can get a job in 2 months so I need an emergency fund of €2,600’, whereas someone with a low risk tolerance might still want 6 months expenses in their emergency fund to feel comfortable.
When trying to figure out what emergency fund you need it can be helpful to think about the most likely unplanned issues you could have. If you have a job that is not fully stable it might be job loss or gap. If you have a car, it might breakdown. If you have children, they might get sick and need doctor visits and medicine. If you own a home, appliances can break. If you are self-employed or work on commission, you might have a few slow months and lower take home pay.
By writing down a list of the main risks you have and the financial impact they would have, you get a picture of what level of funds you need to stave of financial insecurity.
A safe rule of thumb is to have 6 months expenses in an emergency fund.
When you are starting to get your finances in order the idea of 6 months expenses in savings can be intimidating. If you find this the case, start simple and work your way up. Set targets and try to hit them until you get there.
A great point about planning to get 6 months savings in an emergency fund is that is underlines the importance of expenses. The more you can lower your expenses, the less you need in your emergency fund.
An emergency fund also acts as FU (Forget You, or cruder variants) money. Having this FU money allows you to not compromise your values in a work environment. If you are being asked to do something unethical or against your interests or beliefs, you can refuse knowing you have money in the bank.
An emergency fund gives you the basis for developing wealth as you can make investments and long-term choices without worrying about smaller unplanned expenses that can ruin the well laid plans of others.
If you don’t already have an emergency fund, work out what are your most likely unplanned expenses and figure out what you need to comfortably get through them.
If you already have and emergency fund in place, make sure to review it every 6 months to see if it still matches your current risk profile.
Financial literacy leads to reduced stress, better decision making and the ability to plan to meet your personal goals.
Money Boot Camp Ltd.
Call: 00353 (0)871225761