Over the last few weeks, I've talked about how I financially plan each year. The key to having a flexible plan is understanding the purpose of your budgeting — the purpose is to grow your personal net worth from Point A to Point B.
Last week, we talked about personal net worth statements — what to include, what not to include, how to value elements of your personal net worth statement, and how you should be conservative when valuing and including things on the statement.
When you measure your personal net worth today, you define your starting point. Where you want to be at the end of the year mostly depends on your desired rate of return or growth rate.
I personally want to grow our personal net worth by at least 10% a year throughout my working life, but specifically closer to 20% in these early years where our net worth is decisively lower than in the future.
So, if you have a personal net worth of $100,000, you should aim to be at $110,000 or $120,000 by the end of the year.
How you get from $100,000 to $120,000 is your budget. Or your plan. Whichever word you want to use.
Understanding All Your Sources of Income
There's an age old understanding that most people dramatically underestimate how much they spend.
In my experience, it's exactly opposite: Most people underestimate how much they make.
When people think of "income", they think of their bi-weekly or semi-monthly paycheque — the amount of cash that hits their bank account every 14 days.
Cash is, of course, income. But most people have more income than simply their bi-weekly paycheque.
For instance, if you're an employee who has an employer sponsored pension plan, your income should include the employer portion of the contribution to the pension plan.
Your income should also include the growth of that pension plan throughout the year.
If you own your home and have a mortgage payment, only a portion of the payment is an actual expense. If you make a $1,000 mortgage payment, perhaps only $500 of that is actual expense — the other $500 pays down the mortgage and increases your personal net worth.
Your income should also include the increase in the value of your home each year.
Do you have a stock market portfolio? The growth in that portfolio and the dividends paid to that portfolio should be included in your income.
Do you own a rental property? Even if you don't experience a net cash in flow (the rent collected is greater than the amounts paid out for the mortgage and expenses), the rental income helps pay down a mortgage, of which there's a large principal portion and an appreciation in price, and which increases your personal net worth.
These elements aren't exactly "income" the way most people understand "income". But in short, I believe anything that increases your personal net worth should be considered part of your "income" when budgeting how you'll get from Point A to Point B.
The other side of the coin is your spending, which is the part people despise. I don't blame them, honestly.
Discretionary and Non-Discretionary Expenses
I'm a horrible budgeter. My interests wane and waffle throughout the year — sometimes I'm interested in purchasing new clothes and other times I'm interested in purchasing a piece of camera equipment.
A meticulous budgeter will put 1/12th of the amount needed to purchase that camera each month and only purchase the item when they've saved enough.
Or there are people like me, who have absolutely no patience for that.
To work around this and justify my ways, I generally breakdown our spending into two categories: discretionary spending and non-discretionary spending.
Non-discretionary spending is pretty self-explanatory. Non-discretionary spending are the things you can't avoid in life — your mortgage payment (to be specific, the interest portion of the mortgage payment), loan payments, groceries, vehicle fuel and insurance (if you don't live in a region served by public transit), diapers, dental bills, internet, and more.
Many advisors (rightly) include small amounts of cash saving inside this non-discretionary pool. Even if it's $50 every month, I think it's quite wise to include some sort of cash saving in your non-discretionary spending list to add in a little buffer.
Discretionary spending is often considered to be the spending you don't need to undertake. This includes fun things like dining at restaurants, expensive clothing purchases, vehicles, and more. If you can control how much you spend in a given category with relative ease, it's likely a discretionary expense.
How do you get an idea of what you spend regularly? Grab your credit card statement or your bank statements from the last 6 to 12 months and analyze them. Determine your monthly cash outflows and payments and categorize them as discretionary or non-discretionary items. If you normally spend with cash, take your entire cash withdrawal from your bank statement and consider that discretionary spending.
Be ruthless in this step. Find all your spending, categorize it, and include it in your plan.
Next, List Everything
Exactly like that — list your monthly incomes, including your salary, your employer pension contributions, your portfolio growth, your dividends, your rental income, Canada Child Benefit payments, GST/HST payments, and other sources of income into one list. For amounts that are annualized (you receive once per year or aren't received on a monthly basis), divide them by 12 and add them to your monthly list.
Put all your income on the table.
Do the same for your spending. List everything — non-discretionary and discretionary — and divide annual amounts (such as vehicle insurance) into 12 equal monthly amounts.
By the time you're done, you'll have one long list of incomes (a bunch of positive numbers) and a long list of spending (a bunch of negative numbers).
Grab a calculator and sum everything up. All the big positive numbers less all the big negative numbers.
This number reasonably estimates your monthly personal net worth growth (or loss). And it's this number we need to focus on.
It's this number that moves us from Point A to Point B in our personal net worth goals.
Adjusting Your Monthly Contribution Margin to Fit Your Needs
Here we go again — Josh is using an accounting term. In accounting, "contribution margin" measures the amount of cash a sale can contribute to paying your fixed expenses. "Contribution margin", in my personal finance thinking, is the amount of net income you can add to your personal net worth at the end of the month.
So if you make $5,000 in a month and you have to spend $4,750 of it, you have "contribution margin" of $250.
Take your monthly contribution margin, multiply it by 12, and compare that to the amount you want to increase your personal net worth by in the next year.
Given your current "budget", can you meet your personal net worth goals?
If you can meet your personal net worth growth goals easily, do you need to reconsider your goals?
If you cannot meet your personal net worth goals with the current level of "contribution margin", can you analyze your non-discretionary spending to find something to cut out or adjust? Did you miss a specific income in your list?
More often than not, I think people will be surprised by how quickly they can meet their goals using this simple method. I think, in general, people make more than they think they do. And while I expect most people underestimate their spending levels, I think having an understanding of your spending will quickly lead to a few trimmings here and there that will quickly help you meet your goals.
This week has become a little long, so I may summarize everything another week.
In short, if you take all your incomes, subtract all your expenses, and apply the difference to your personal net worth starting and ending points, you'll quickly realize if you need to trim some spending or if you're already meeting your goals.
Remember, any personal net worth growth between 10% and 20% per year will net you a sizeable net worth after 30 years of work.
Thanks for reading this far. I hope you've had a great week and I wish you a great weekend and a healthy week ahead.
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