Why Conventional Wisdom On Following A Budget Is Wrong And How To Manage Your Money Better

The Case Against Following A Budget
Following A Budget Is Not The Path To Financial Independence

The conventional financial advice you get from mainstream sources is to keep a strict budget of your monthly income. That advice is wrong. This can actually hinder you from achieving financial independence. If you look at how large companies manage budgets, you will see how flawed the idea really is.

 

Budgets In Large Companies:

Large companies have many departments and determine what the operating budgets of these departments should be for the year.

Where I worked, in the Engineering Department, we might have had a budget of $100 million for the year. This was a publicly traded company so the people who were responsible for the budget in our department weren’t actually spending their own money. They were spending the company’s money. Their only concern was that they didn’t go over the budget because it will affect their yearly bonus. But what happens to them if they are significantly under budget at the end of the year? Does the company give them a bigger bonus or a cut of the money they saved? No, of course not. In fact, if they are under budget at the end of the year, the company will give them less money for their budget next year figuring they gave them too much last year. So what does the budget manager do if he knows that he will come in under budget? He goes on a spending spree in the last few days of the year.

In our case that usually meant buying equipment for jobs that we might have next year or even just buying rooms full of laptops or anything else that we may need next year or down the road. After all, it’s free money right? Use it or lose it. It’s actually worse than that because if he doesn’t use it all, he gets less to use next year. Now, does this sound logical to you? It doesn’t to me but, based on the consequences of coming under budget, that is what it leads the budget manager to do. It’s not his money so it’s like having a bunch of money that expires on December 31.

Now think about what would happen to the extra budget money if this was a small company privately owned by the founder. Would he blow that extra money just so that he doesn’t under spend the budget? No, because it’s his money, and anything he saves by under spending the budget goes right into his pocket! This is how you should think of your own finances.

 

Personal Budgets:

The mainstream financial advice is that you allocate your  monthly income into a budget. If this advice is so good though, how come most people live paycheck to paycheck and are nowhere near being financially independent? It’s because keeping a budget is artificial and causes you to spend money you would not normally spend just like the manager in a large company that buys things he doesn’t need just because he is under budget.

Most people budget for categories that they think they need or are told they should budget for like restaurants, clothes, entertainment, car payment etc. When they are finished with their budget, they come out with $0 at the end of the month. Now, they may budget some money for savings but it is usually a small amount. So with a budget like this, if you allocate $300 a month for restaurants, but at the end of the month you only spent $100 on restaurants, what are you going to do? You will most likely go out and make sure you spend that other $200 at a restaurant right?

You see how keeping a budget makes you spend some artificial  predetermined amount? It also keeps you in the mindset that you need to spend money on these things every month. What you should do is start from the idea that you will try to save as much as you can every month and only spend on things you actually need or want within reason. If you need some new clothes this month then buy it, but if you don’t need any next month there is no reason you should have a budget item that forces you to buy more clothes. Save that money instead. This gets you into the mindset that saving and investing the money you worked for is more important than some of the things that you would normally buy. It makes you think twice about if you really need it. If you do this, you will eventually find that some of the things you thought you needed are not really that important.

Try to think like the owner of a private business. Every dollar you don’t spend adds to your wealth. Remember, for every year of expenses you save, you can stop working one year earlier.

When Is The Optimal Time To Retire Early?

Most financial advisers tell you that the optimal time to retire is some time after 65 depending on how much money you have saved for retirement. To me, the optimal time to retire is way before that. So when should you retire?

The short answer is as soon as possible. Of course it depends on a lot of things including your family situation, future obligations, health, and how comfortable you are with the unknown. There are a lot of variables and what works for one person obviously does not work for everyone. That doesn’t mean you can’t take a specific case and tweak it to work for you. I’m going to use the example of my situation because that is the example I know best.

Let’s make some assumptions:

I am a single male with no kids therefore I don’t really care if I have any money left when I die to leave to any relatives.

Assume a life expectancy of 75 years old.

Assume you will not receive any Social Security.

Assume no debilitating health bills.

To compensate for unseen contingencies, we will assume that the money you have when you retire will equal your yearly expenses times the years until you are 75. In other words, if you retire at 45 and your living expenses that year are $25,000, then you need 30 x $25,000 = $750,000 to retire. I am not including the growth in your investments or the increase in your living expenses due to inflation.  In reality, if you have $750,000 today and only assume a 4% growth rate in your investments, while assuming a 3% yearly growth rate in your living expenses, you will still have about $350,000 at the end of 30 years.

First let’s see what a typical worker’s lifetime of work, retirement and savings looks like if they follow the path of pretty much spending what they make and probably only saving in a 401K account:

The Typical Worker’s Retirement And Savings Rate.

As you can see, they probably have about 5 years of living expenses by the time they retire at 65. They might get a small pension and Social Security and this covers a 10 year retirement. For some people this is fine.

 

Now let’s see the different retirement scenarios for people who start saving, investing early, and actively live below their means:

This Is A Person That Saves And Invests But Never Retires.
This Is A Person That Saves And Invests But Never Retires.

This is not a bad outcome if you love your job or career so much that you couldn’t imagine doing anything else with your time. The bad part is that you saved way too much money so you died with a fortune. It’s kind of like how all the money goes back to the bank when you finish playing Monopoly. Thanks for playing.

 

This Is A Person That Saves And Invests And Retires At 65.
This Is A Person That Saves And Invests And Retires At 65.

This person has about 10 years of retirement just like the person in the first graph who didn’t save much, yet also retired at 65. The only difference is that this person dies with way too much money left.

 

 

This Is A Person That Saves And Invests And Retires At 45.
This Is A Person That Saves And Invests And Retires At 45.

This person retires at 45 and still has a lot of good years left to do the things they want to do without being too old or tired to try if they were much older. They will die broke or almost broke but who cares?

 

These are obviously very simplified examples, but the point is that you really can retire early if you are serious about it and plan for it. There is nothing noble about ending up with a lot of money when you die, especially if it comes at the cost of working many extra years unnecessarily.

I have been guilty of this myself. I wanted to quit my job years earlier, but my cautious nature always kicked in and said to me “Every year you stay at work, you’re saving about two years of living expenses.”. The truth is that I never made the decision to leave, they made it for me. I think they did me a huge favor.