Month: September 2012

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“it is” vs. “i will”: prescriptive and descriptive budgeting

A lot of people shudder when they hear the word “budget”. And why shouldn’t they? The popular view is that a budget is like a diet writ large — but instead of just limiting your eating, it’s limiting every fun part of your life! No wonder virtually no one keeps a budget — trying to actively limit every single aspect of your spending is a sure recipe for burnout!

Luckily, budgeting doesn’t have to be like that. Enter descriptive budgeting.

Prescriptive budgeting is what you traditionally think of when you think of budgeting: “I’m going to write this number down and pinky swear (or, even better, establish a system like the envelope method) that I’m not going to spend more than X amount on Y.” It’s certainly not a bad thing, and it’s often quite necessary, but it’s not the be-all and end-all of budgeting. As I mentioned before, trying to make it the be-all and end-all can quickly sap your motivation.

Descriptive budgeting is simply entering into your budget what you predict you will spend. You’re not making any effort to throttle back; you’re just stepping outside yourself and saying, “Given what I know about myself (or my family), and what YNAB/mint.com/Quicken says we’ve spent in the past, how much will we probably end up spending this month?” You already use this for mostly-constant bills, like auto insurance or your rent, and even bills over which you only have partial influence, like your utility bill.

Note: you can combine the envelope method and descriptive budgeting! In other words, just because you’ve decided to pay cash for everything doesn’t mean that you’re actively limiting your spending everywhere. For example, I know some dedicated Ramseyites who pay cash when fueling up their car — not because they’re trying to cut back on gas, but simply because they don’t want to use plastic anywhere. In most of these cases, they use descriptive budgeting to allocate what they think they’re likely going to spend to that envelope. (A little more, actually, because running out of gas money before you run out of month would be pretty disastrous to most Americans!)

So to summarize: with your descriptive budget categories, you’re just putting down What It Is, while with prescriptive categories, you’re putting down What You Want To Do. “OK,” you say. “That’s an interesting little bit of semantics, but…so what? Why even bother with descriptive budgeting at all?”

Fear not — these questions and others will be answered in next week’s post!

 

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defeating your worst enemy

Last week, we talked about how your own worst enemy when it comes to investing is yourself. So how does one go about defeating an enemy so subtle, so intelligent, and so very…you? Well, here are a few systems that can help.

Have a written plan, and a regular date in your calendar for reviewing it. Whatever your plan is — whether you’re a businessman or an academic — write that plan down. If you don’t have a written, solid plan, it’s a good bet that you’re going to let your emotions change that plan whenever you feel like it. If the market crashes, it’s too late — if you sell then, you’re just buying high and selling low! So write a plan, review it once every 6-12 months, and only change the plan when it’s up for review. This will keep you from trying to chase performance and falling victim to that dreaded Behavior Gap.

In particular, have a systematic rebalancing plan. If your investing plan is asset allocation based — and I recommend that it should be — make sure you regularly check to see if it needs rebalancing. Notice that I said “check”; don’t just mindlessly rebalance every quarter, or trading costs could eat any gains you may have gotten. No, it’s better to have a concrete plan in place, with rules like “if the absolute percentage of international stocks is more than 5% from the target, rebalance” or “if any individual stock becomes more than 2% of my portfolio, rebalance”.

Stick to the Yahoo principle. William Baldwin at Forbes wrote an article in which (along with recommending fee-only advisors) he outlines the Yahoo principle: buy things that trade in large volumes with prices you can see. Read the article for his reasoning, but I only needed one story to convince me: a friend of mine, incredibly intelligent, who had been investing since before college, had money tied up in some fancy dutch-auction securities which, after 2008, simply would not sell, at any price. Sure, nothing ventured, nothing gained, but there’s such a thing as the reward not being worth the risk.

Once a year, run the Overnight Test. This gem comes from Carl Richards. The idea is simple: once a year, imagine that one night, some crazy guy took all your assets and liquidated them, but left the proceeds in your account, so you wake up and find that everything you have is in cash. What would you buy? If it’s not the securities you currently own, why do you still own them?

These are some of my favorites, but it’s by no means an exhaustive list. How about you? What are some of your favorite systems?

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your own worst enemy

There are two stories that I am tired of hearing.

One is a story of greed. I heard it a lot around the turn of the century, and again just before the 2008 crash. It took many forms: day-trading with a 401(k); dumping Oracle stock for that of a smaller company because the database giant was “only” scheduled to double; after some clever analysis, placing a disproportional bet on muni bonds. In every case, the portfolio in question became dangerously out of balance, and when the inevitable crash came, it lost far more than its share. In the cases where its owner was approaching retirement, the impact was disastrous.

The other is a story of fear, and I’m hearing it a lot now.  Retirees whose entire portfolio is in cash, and pre-retirees who are considering not bothering with their 401(k) anymore — because it seems that no matter how much they put in, the balance stays the same or goes down.

Of course, neither of these stories has a happy ending — they’re the source of the Behavior Gap that Carl Richards is so fond of talking about. It’s easy to blame them on fear or greed, but that’s really only part of the story. A more sinister villain is also at play here: recency bias, the well-known tendency of humans to believe — irrationally! — that things are going to stay the way they are, whether good or bad. In 1999, everyone knew that tech stocks were going to continue to go through the roof; in 2006, everyone knew that real estate was a sure bet; in 2008, everyone knew that the stock market was going to plummet forever. (You might ask yourself: what does everyone know now?)

Recency bias is a powerful enemy, though. It masks itself as rational behavior — why keep my money in bonds when stocks are going to continue to outperform? Why keep my money in stocks when they’re going to continue to remain volatile? And in our effort to stay informed, we expose ourselves to an amplification effect from the financial media (whose job, recall, is not to give us unbiased information, but to sell copy) that barrages us with provocative headlines like “Are Stocks Dead?” and “Is This The New Normal?” It’s enough to make even the most rational investor bail out (or jump in, as the case may be).

So what’s a poor human to do? Well, you know my answer: systems. In the case of investing and saving for retirement, there are some handy weapons in your arsenal for dealing with your own worst enemy (yourself); stay tuned for next week’s post, when I’ll introduce you to some of them!

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systematically solve your financial problems, part 4

So: you’ve identified the problem, chosen a system, and established criteria for success. Now all that’s left is to implement the system and wait for success to find you, right? Well…no. As I mentioned last week, every system is an experiment, so as with all experiments, you need to periodically review and tweak your system.

This is what trips most people up. Once a plan is in place, they feel this rush of relief, almost as if they’ve already beaten whatever problem they’ve come to solve. So they go on their merry way…and are completely blindsided when their system blows a gasket or simply fails to start. No, every system needs regular care and feeding, whether it’s weekly, monthly, or even yearly.

Example: a budget. You get tired of not knowing how much money you have to spend, so you sit down one day, go through your receipts, and come up with one. All the numbers add up, everything looks great…until next month rolls around. You find that you overspent on eating out, so you grit your teeth and resolve to underspend by that much the following month. But that month you have friends in town, so of course you eat out even more, and find yourself hundreds of dollars in the hole…and you give up. It just wasn’t working for you.

Well, of course it wasn’t! Remember: every system is a continual experiment. Instead of just throwing up your hands, tweak your system. Maybe you need to allocate more money to eating out. Maybe you need to switch to the envelope method. Whatever it is, it’s almost guaranteed that you won’t get it right the first try…and what works today may not work a year from now. No budget is ever exactly on target, and there is no such thing as a “normal” month; what makes budgets work is when you sit down each month and adapt your budget to Real Life. (By the way, YNAB is excellent at this sort of “rolling with the punches”.)

Or maybe you decided that making a budget was exactly what you and your spouse needed to see eye-to-eye. So you sit down, make a budget, explain it to your spouse, they agree…and then promptly blow it out of the water the next time they see a sale. You could give up…or you could tweak your system. A “monthly money date” is an excellent way to make sure you and your spouse are on the same page re: finances. (Oh, and the system of “just not talking about money at all”? That won’t work. I promise.)

Now, this sort of thing doesn’t come easy to most; we’ve got lots of other things to worry about, and taking time out for our finances doesn’t often make the priority list, even when we know it should. This is where financial coaches really shine. I’m not talking about normal financial advisors, who are mainly interested in selling you insurance and investment products; I’m talking about the ones who work with you to create and maintain your financial systems. Like a personal trainer, they not only give you the information you need, but they also guide your development as you grow, regularly reminding you to tweak your systems — from budgeting to investing — and giving you ideas on how to do so.

Unfortunately, while you can’t throw a rock without hitting a financial advisor, the kind of financial coach I’m talking about (who often does financial advising and then some) is a bit trickier to find. There is my own practice, of course, and I’d be delighted to work with you; also, I highly recommend my friend Jennifer Jaime, a CPA and excellent financial coach.

Whether you get an expert to help you or no, remember this: financial success — or failure! — rarely comes from a single decision. Rather, it comes from your systems, and the day in, day out decisions that come from them. Care for them consistently, and you’ll get where you want to go.