The Simple Money Mistake You Make Every Day
When it comes to money and personal finances, I find that most people tend to prefer complexity over simplicity and excitement over routine and predictable ideas and actions.
We give lots of attention to the hot new financial trends such as crypto, NFTs, SPACs. But we often fail to grasp the fundamentals of good money management. Things like controlling spending, increasing savings and lowering the cost of investing and insurance.
Back To Spending Basics
Before you get seduced by the next financial fad or get-rich-quick scheme, have a good look at your basic financial management processes.
It doesn't matter how much you earn. If you spend all of it (or more) on daily lifestyle consumption, you will never get ahead financially.
Many people I speak to about controlling daily spending seem to make the same simple mistake. And that mistake is not understanding the difference between irregular expenses (whether they are essential or fun items) and emergency or unexpected expenses.
Irregular Expenses
Irregular expenses are things that you need (i.e. essential) or want (i.e. fun) to spend money on, but which aren't a monthly amount. These expenses can be fixed or variable.
The table below shows examples of expenses that fall into these categories.
Whether they are fixed or variable, you have to make a monthly allowance in your spending plan for this expenditure. And you have to place that money into a separate account. In my Smart Spending System, I call this the 'Smoothing' account, as shown in the graphic below.
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By 'spending' these irregular expenses on a monthly basis, by parking them in the smoothing reserve until the money is needed, psychologically it's easier to feel in control with minimum effort.
What's An Emergency?
An emergency is an unexpected expense or sudden drop in income that is unknown in terms of how much and when (if ever) it will happen.
An emergency:
Is your engine blowing up and being unable to travel to work. IT IS NOT routine car repairs like servicing and normal wear and tear like replacing tyres. You have to make a monthly allowance for that.
Is having your broken tooth fixed because you are in pain. IT IS NOT getting a tattoo that you decide to get on a whim.
Is needing to hire a car to get to work because yours is in for repairs. IT IS NOT staying out late and getting an Uber home because you drank too much.
Is our partner suddenly being made redundant. IT IS NOT failing to get the bonus you were counting on and that mentally you'd already spent.
Cash is generally a poor long-term investment. For that reason, only hold as much in your emergency fund as you think necessary to enable you to cope with the risks of unexpected expenses or a fall in income.
That might be one, three, or six months' expenditure. It might be one or two years' worth! Hold as much as your circumstances and personal preference dictates.
I like to hold 12 months' core living costs in my emergency fund. If it dips below that amount, because I have a genuine emergency, then the first thing I do is replenish it. This helps me sleep well, feel less anxious when stockmarkets take a tumble, and enables me to take bigger risks elsewhere with my wealth.
However much you hold in your emergency fund, make sure that you keep it separate from your smoothing fund. You don't want to get confused about the different roles that each account plays.
Your smoothing account receives a monthly allocation from your income, equal to between 1/10th (if you want to really cautious) to 1/12th of all your fixed and variable expenses that aren't monthly. Your emergency fund holds your desired multiple of essential living costs.
Get this simple money management skill right, and everything else will fall into place. Then you can take time to evaluate that latest new financial fad.