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.

Brexit vs. Bremain: The Danger Of Following What Everyone “Knows” To Be True

It is a few minutes past midnight on Friday June 24, 2016. The news all over the internet and the T.V. is that the vote on whether the UK should leave EU is now confirmed, and the “Leave” has won over the “Remain”. Is this a big deal? Well if the reaction in the financial markets is any indication, the yes, it is a really big deal. But I don’t live in the UK, so why does it matter to me in the US? Well for one thing, the S&P 500 futures were down about 100 points, or about 600 points down on the Dow. The British Pound against the US Dollar is lower than it has been since 1985 they are saying on CNBC. Asian and European markets are all down heavily. Gold is up about 6%. Okay, so I just gave you the run down at this instance in time of some of the global markets, so what does that prove?

Well in the last week or so, it was “common knowledge” that the UK would remain in the EU. This “fact” was so well known that most of the smartest investors have been bidding up the British Pound and the US markets because it was a foregone conclusion. What we are seeing now is that when everyone seems to know something as obvious, it is not always so. Also, when something is obvious there is not much money to be made because everyone is already on board. The bigger risk is in the opposite happening.

Here are some more obvious truths from the past:

1989 The Nikkei in Japan is almost at 40,000 and land in Tokyo is so expensive that a $100 US Dollar bill cannot buy the land that it covers if you laid it down on the ground in Tokyo. What did everyone “know” at this time? Everyone knew that Japan would take over the world and every MBA better learn Japanese and they are not making any new land in Tokyo.

1999 NASDAQ is at 5,000. Everyone “knows” that tech and the internet are the wave of the future and that dividend stocks are worthless because the biggest gains come from growth stocks.

2006 The US National Housing Price Index has never gone down on a national level, so naturally it never will. Everyone “knows”, after talking to a real estate agent, that you should buy more house than you can afford because it will be 20% higher next year. It’s even a better idea to lie about how much you earn and get an adjustable rate mortgage because even if the loan resets higher than you can afford, you can just sell the house and lock in those sweet profits.

2016 The year is not over yet, but what does everyone “know”? They all know that the key to early retirement is to put all your money in a low cost index fund because the stock market always goes up for as far back as I can remember (which is 2010).

The point I’m trying to make is that the so called experts are often wrong. I can be wrong, and you can be wrong so why put all your eggs in one basket? If you owned only a diversified basket of stocks, you would still be down a lot because when markets go down everything becomes highly correlated. If you owned some stocks, some bonds, some real estate, and some gold, you would not be as exposed to being wrong on one idea or asset class. This also goes for where you keep those assets. If everything you own is in one country that is the same as betting all your money on one idea.  Yes, I “know” betting against the US has been a losing proposition, but I also remember when it was common knowledge that US stocks returned 14% over the long term. Now it seems that it’s common knowledge that dumping all your money into an index fund no matter how high the market is will get you 6% over the long term.

Here is a quote from a very good book about manias and bubbles:

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”

Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay