Why Budgeting can be Dangerous

Over this weekend, we went down a Youtube rabbit hole: The One Rand Family. This was a Sanlam initiative (advertisement) during the month of July which was National Savings Month. The original version was The One Rand Man, which ran during July 2014. 

The big idea was that the participants got their whole salaries for the month in the form of one rand coins, and locked away their plastic money for the duration. This not only gave them a very visual sense of what was going on with their money (stacking up piles of coin-filled plastic containers makes you aware of the size of your car repayments on a very visceral level) but also made them think twice before spending. When you've actually got to dole out your last few piles of one rands, it makes you think more carefully about whether you really need whatever it is. And when you've only got a couple of hundred rands and 9 days left in the month... well, then you really start changing your spending behaviour, at least temporarily.

Watching all of their episodes, as well as some other interviews with the participants, it seems that the biggest challenge for them was not making use of overdraft/credit card facilities when the cash flow got tight at the end of the month. 

Even for those of us who aren't quite as extreme as the One Rand Tribe, using credit as an escape route when our money has vanished is a very bad idea, short of a once off emergency. Because unless we have saved a lot already, this means that we are spending next month's money this month, with no particularly wonderful prospect of making up for it next month. Borrowing for lifestyle expenses means that a month's salary is not enough for a month's lifestyle; and it definitely won't be enough for a month's lifestyle plus debt repayments. Ask yourself: what will be different next month? The sad truth is that next month we'll have the exact same problem except probably worse: after all, your salary won't be any bigger; it still won't be enough to pay for your lifestyle. 

If you aren't careful, you'll end up getting further and further behind, unable to pay the full credit card bill every month and therefore creeping further and further into debt.  As soon as you start paying the minimum payments rather than the full balance it is scarily easy to end up in a situation where you are constantly a month or more behind: and then half your income is going to disappear into repayments that hardly even touch the capital of your debt but instead scrabble around in the foothills of a massive interest rate. 

A truly alarming number of South Africans seem to be in this predicament.

The beast of the night called DEBT makes a guest appearance...
Photo credit: GotCredit at  www.gotcredit.com (CC-BY 2.0)

This got me thinking about BUDGETING: the process of trying to fit your lifestyle into your monthly income.

Here is the usual idea behind budgeting, one to which I have unfortunately subscribed for many years: 

1. List all the expenses you can't avoid, such as rent and utilities, tax, medical insurance and so on. These are usually the ones that bounce straight out of your bank account as soon as your salary arrives. You should know what they are. You probably can't do anything much about them. The exceptions to this are debt repayments, which also come off at this stage, and which you can definitely do something about (pay them off quicker!).
2. See how much money you have left. This is usually a lot less than any of us would like. Now allocate as much as  you think you will need for other essentials like food, petrol and school fees.
3. Whatever is left is for spending however you like. This is where you "budget" for eating out, clothing, movies and holidays: all the things you'd actually like to spend your money on.
4. If by exerting colossal effort you have managed to ensure that there is some money left at the end of the month, save it.

Now, budgeting like this is definitely better than not budgeting. At least you know where your money is going, and you have a reasonable expectation of not going into credit for the essentials of life. Depending on your self-control on step 3, this process will even prevent you from going into credit on the non-essentials: yay!

BUT

BUT 

BUT

Why Budgeting is Dangerous:

Step 1 shouldn't have any debt in it whatsoever. Making debt repayment come off like a normal expense makes it feel like it's okay. It is not okay to be in debt. Half of the reason South Africans are in such a debt hole is because of the perception that debt is like an awkward uncle: not ideal to have around, but everyone has one, so it's fine. If you have a debt, then budgeting should involve Step 1, Step 2 and NOTHING ELSE until the debt is paid.

Step 2 is open to (mis)interpretation. It is too easy to make yourself believe that something is essential, when it is actually a discretionary item. Here is an example: for the first three years after we got married, we had yoghurt with our breakfast muesli every morning. Once in a while we would look at the price and wince - because yoghurt is a lot more expensive than milk - but we convinced ourselves that it was good for us, and therefore necessary. In fact, once you look at the sugar involved in most yoghurt, the "good for us" premise is unlikely. And unless you have a very specific medical situation no-one would say that the yoghurt cultures (or whatever they are) are necessary for health. The main thing healthwise for ordinary people is the calcium: and that is available much more cheaply in milk. It takes a huge amount of self-control to be totally honest with yourself about the true essentials of life, particularly when it comes to food. A similar process often happens with petrol - we use too much of it, because we drive too much. "Allowing" this expense in our budgeting can make us feel like this is an acceptable situation.

Step 3 is a disaster waiting to happen. We all know that the "I want" section is where budgets fall apart. When I was a student I budgeted to buy one soft drink per week, on my way to tutoring. This was my discretionary spend. But guess what? When I walked past the shop on other days, sometimes I brought myself a soft drink anyway, because what's one extra soft drink? Yet if I did this once per week, my discretionary spend would have doubled. Yes, this is a silly example, and probably made no difference to my financial health. But when you're earning more than a student pittance, the tendency is to repeat this pattern in an increasingly unhealthy volume. R400 becomes R600, because I've worked hard and deserve it. R300 becomes R450 because it was a special deal and worth every cent. R200 becomes R370 because I don't want to look stingy in front of my friends. Making it okay to spend some unnecessary money often opens the door to making it kind of okay to overspend - and even to use credit to fund your lavish lifestyle. 

Putting discretionary spend before savings is a major catastrophe: but it is a catastrophe that too many of us overlook in our monthly budgets. If your budgeting process looks like the one I outlined above, you are treading water. And yes, that is better than drowning. But at the very best, you are probably making a small contribution to your pension fund as required by your employer, and perhaps perhaps saving something at the end of the month. But over all, you are (hopefully) breaking even, and making little to no provision for the future. Yet you probably feel as if you are doing quite well. But if a wave comes along... you could too easily go under. News flash: your financial position may not be as awful as other people's. That doesn't mean you're in a good place.

Budgeting is the process of fitting lifestyle into cash flow, not the other way round!
Photo Credit: Tax Credits at taxcredits.net (CC-BY 2.0)

What does healthy budgeting look like?

Don't get me wrong, budgeting is a really important and helpful part of living a frugal lifestyle, fueling the independence engine and (hopefully) reaching financial independence. But we need to budget in a productive way. Here are some ideas for healthy budgeting:

1. Budget descriptively, not prescriptively. Budgeting should be a process of observing your own spending habits. This means that you can plan cash flow effectively, and work out if and when you will be able to afford those unavoidable large expenses. It also means that you can safely save your maximum without being afraid of accidentally running out of grocery money.
2. Save first. I've said this time and time again, but looking towards the future cannot be an afterthought to your month. Use your descriptive budgeting to work out how much it is possible to save, and get that amount out of your bank account ASAP, before you accidentally spend it.
3. Budget with a critical eye. When you look at your spending for last month, look out for danger areas. Perhaps when you look back you notice a gradual creep in expenditure on clothing. This enables you to cut back in those areas next month.
4. Don't budget for wants. If a "want" spending opportunity comes up, either do it or don't do it, based on careful consideration of that situation. Don't have a general rule like "up to R200 is okay for discretionary items", because the truth is that sometimes it is and sometimes it isn't. Make each choice deliberately, not automatically. (Imagine paying for it in one rand coins if you think it will help!)
5. Budget long term. Create a spreadsheet or plan for the next ten years. Where would you like to be? This helps you to keep an eye on the bigger picture, without getting too bogged down in month to month expenses.
6. Whatever you do, don't create a series of ineffectual and unrealistic budgets which you know you'll never be able to follow. This will just make you feel bad about yourself OR make you feel unhelpfully good about yourself while making no actual change to your financial health.

Overall, your budget should be a means of you (and your spouse/family) planning financial choices sensibly. It isn't a magic spell which will make all your financial problems go away. As with all financial tools, if a budget is used badly, it will have a negative impact on your financial situation. But used with caution, it can be enormously powerful.

Postscript/PostInvasion from Mr Cent(ri)frugal Force:

You may find some of these tools helpful for putting together a healthy budget:

Picking the right tool can make all the difference.
Photo Credit: Lachlan Donald (CC-BY 2.0)

• Google Sheets - an online spreadsheet tool. I like to keep my descriptive budget in the cloud so that I have access to it anytime and anywhere - it's also easy to share it with others (once I've made a more user-friendly version of my spreadsheet I'll share it on the blog).
• 22Seven - this really cool company (now owned by Old Mutual) has an app (and a web version) that pulls in all your account balances from all your online accounts that you choose to link to your 22Seven account. You'll need to do your own research and choose how comfortable you are putting your passwords into their service, but their security appears to be pretty solid. Their software tracks your spending and categorises it for you - this is a very good way to see exactly where your money is going. Personally, I prefer to micromanage things so I like my spreadsheets and accounting software (see below). But I've been making use of 22Seven as well (mainly to decide if I'd like to recommend it on the blog) and I've been pretty impressed with them. They also have a blog which is pretty good - you should go check it out. One word of caution - the service is free, but they're probably hoping that you'll make use of them to save in a Tax Free Savings Account. The signup process looks ridiculously easy and the fees are not too bad (0,68%). But you can definitely find lower fees elsewhere - this 0,68% is a fee over and above the fees paid on whatever unit trusts you'll be investing in. Fees really matter so you'll want to do your research on this one. I'll try to do a blog post about fees soon.
• You could also make use of some accounting software. Back in the day I used to make use of Microsoft Money, but I found the "category approach" for income and expenses not as helpful or powerful as a proper "account approach" that one would use in accounting. This is when I switched to gnuCash which is free and cross-platform. You can even turn off words like "debit" and "credit" and make them display something like "money in" and "money out" if that helps you ;-)
• Other than the above I haven't dabbled in any other budgeting tools, apps or services. If you have had a particularly good experience with other apps let us know in the comments!

Happy budgeting!

jjdaydream & Mr Cent(ri)frugal Force

Investing Basics I: Asset Allocation

At this stage we've established the importance of saving money in order to invest it. The Financial Independence Engine is most potent when powered by the stock market, but there are many ways to access the stock market so we'll explore some of these as we go along. Non-stock investments should not be overlooked - they add value at any stage of your financial independence journey and the role they play will change as your needs change.

This mini-series will be about where your money is (or will be!):

1. what form it's in (cash, bonds or stocks), and in what proportions
2. which companies and parts of the economy you've invested in
3. what type of financial product you invest in (fixed deposit, money market, retirement annuity, unit trust, ETF, tax free savings account etc.)
4. which financial institution you use as a platform

Let's start by understanding the different forms in which you are able to invest, why you would choose each form, and how you should decide on the approximate proportions of each.

Different forms of investments are called different asset classes
Photo credit: GotCredit at www.gotcredit.com (CC-BY 2.0)

Asset allocation
There are three main asset classes: cash, bonds and stocks/equities. In the investing world you might come across the idea of asset allocation. This is simply the ratio in which your assets are spread across these asset classes.

Cash
Essentially anything that earns interest counts as cash. Money placed in a savings account, fixed deposit, money market fund or similar are all examples of cash. In a previous post we established that cash is not the investment we are looking for because anything invested in cash typically only just about keeps up with inflation (sometimes not even). 

What cash investments offer that the other asset classes do not offer is accessibility. If you need money in an emergency or for day to day expenses the last thing you want to do is to be forced to sell off some of your longer term investments at a bad time - for example when the markets have taken a large (but temporary) dip. 

We have about 4,5% of our investments in cash form (Capitec bank accounts and Allan Gray Money Market Unit Trusts) and the rest is in as aggressive a form as we can make it. The cash component of our investment represents more than six months worth of expenses which is available in case of emergency and for cash flow. Building a buffer like this is important so that you never need go into debt. The cash component of our investments enables us to be more aggressive with the rest of our investments.

Bonds
When you lend money to an institution (or even the country itself) for a fixed period of time for either a fixed or variable interest rate you have yourself a bond. It's the exact opposite of the bond you might have on a house. Governments and companies make use of bonds to raise funds for pretty much anything - but since they're getting money they don't actually have yet they need to pay you interest for the privilege of having access to your money. 

Bonds are typically considered more risky than cash, but less risky than stocks. We haven't invested in bonds directly, but we definitely have exposure to bonds through the various unit trusts we've invested in.

The stock market... scary, or not really?
Photo credit: Andreas Poike (CC-BY 2.0)

Stocks / Equities
When you buy stocks or equities, you are essentially buying a small part of a business or group of businesses. You then share in the profits or losses of that business, either in the form of dividends or growth. Your shares in the company grow as the business grows.

The stock market is where you will make returns well above inflation if you're investing for the long term. However, in the short term, it is very possible for your stocks to decrease in value, which makes this seem like the most "risky" form of investment. Actually, the risk isn't as bad as it sounds: the risk isn't really that you will lose all your money (short of a catastrophe) but that at the moment you want to sell your shares they won't be at their most valuable. If you are able to wait for the correct moment to sell (either because you have time on your side because of youth, or because you have a good cash buffer) then this risk is minimised.

The real risk is losing out to inflation in the long term. Not the stock market. But it can definitely feel like it at times!
Photo credit epSos.de (CC-BY 2.0)

If you're investing over a long time horizon (30 years and more) then the risk of losing in the stock market is virtually zero. The real risk is not being in the stock market and losing the race against inflation. The longer you are invested for, the lower your risk.

Instead of working with the traditional asset allocation of "cash:bonds:stocks" we think of our asset allocation as as "things that roughly keep up with inflation : medium growth investments : high growth investments". The medium growth investments are more balanced, are typically Regulation 28 compliant (retirement annuity regulation that allows maximum 75% exposure to equities within the retirement annuity) and we're aiming to get about 5% above inflation on these. The high growth investments are pure equities and we're aiming for about 7% above inflation in the long term on these investments. 

We're very young so we've maximised our exposure to the stock market through unit trusts and more recently passive exchange traded funds (ETFs). These are simply mechanisms by which you can diversify (invest in lots of different businesses so that the risk of your chosen business failing is minimized) and reduce investment costs - more of that in the next Investment Basics post!

Pillar 2: The Financial Independence Engine

Pillar 2: The Financial Independence Engine

(aka sensible investments)

Recall that the second pillar upon which a financially independent life is based is choosing sensible investments which will grow faster than inflation. You need to choose investments that give the biggest possible rate of growth (i in the compound interest formula). In this post I hope to give some background to the options available to you.

Our Financial Independence Engine. Next stop, "Freedom!" Choo Tjoe!
Photo credit State Library of Queensland (no known copyright restrictions)

Saving vs Investing

Firstly, it's important to make a distinction between saving and investing.

Saving is a verb - it's what we do as we build up Pillar 1. We live a frugal lifestyle and the money that we're no longer spending on things we don't need we save. But once the money has been saved it has to be put somewhere.

Savings is a noun - it refers to our saved up cash.

Cash in a treasure chest may look pretty, but it's the Engine we are looking for.
Photo credit Tom Garnett (CC-BY 2.0)

 Now cash doesn't necessarily mean actual coins and notes. It can refer to something like a bank account, a fixed deposit or a money market fund: where your money is somewhere invested in actual coins and notes, and (some) of the interest on that is passed on to you. This is what we call a cash investment.  The thing about all of these cash investments is that they won't be working hard in the way that you need them to in order to build up Pillar 2. Even when you're earning interest on your cash (alarmingly NOT always the case in South African banks), this interest is usually in line with or lower than inflation.

Cash is not King
Cash is a Lazy Prince who is vulnerable to the Vampire of Inflation

Inflation is a Scary Vampire, but there is a way out!
Photo credit Enokson (CC-BY 2.0)

At some point I'll do a post all about inflation. For the moment, all you need to appreciate is that inflation is the rising price of goods and services as time progresses. Inflation is the reason that prices go up and why salaries need to have "cost of living" increases. Inflation has hovered around 6% in South Africa for the past few years and at the moment it's about 4,5% - so let's just simplify things and say we're dealing with an inflation rate of 5% (to see historic inflation rates click here). Now not all goods and services rise with inflation - some rise faster and some rise slower. But it's a good way to estimate the price you can expect to pay for something from one year to the next - something that costs R100 today will probably cost about R105 next year.

The problem, of course, is that although your cash is growing (hopefully) it isn't necessarily growing fast enough to counteract the effects of inflation. If you earn R3 in interest but the price of your groceries went up by R5, you've actually lost R2; even though you might have thought that your savings was growing!

If you are getting 3% in interest (since we're hoping to be earning on significantly more than R100), that isn't good enough - over the course of a year your savings will still get effectively smaller by 2%. Do this every year for 10 years? You've lost a lot of money. It's still more actual rands than you started with, but it can't even buy the same amount as you could at the beginning. You are further from financial freedom than ever.

If you don't want to lose out to inflation then you're left with a few options:

1. Spend your money now before the Vampire of Inflation sucks its value dry.
2. Invest your money in something that grows at the same rate of inflation.
3. Invest your money in something that grows faster than inflation. 

The first option seems attractive - spend now before prices go up next week. Logical, right? But with this approach all we're doing is spending, not saving. We'll never have our money working for us and growing with compound interest because we'll never have any money. So let's scrap this option immediately. It goes against Pillar 1 because it will leave us with no fuel for our financial independence engine (Pillar 2).

And who would choose the second option if they could choose the third option? So let's see how to achieve growth faster than inflation.

We need to save money and then once we've saved it we need to put it into a suitable investment. So far we've determined that this suitable investment is not cash under the mattress, a bank account, a fixed deposit or money market. So what's left?

The Stock Market

All evidence spells out "Stock Market" as our Engine of choice
Photo credit Simon Cunningham (CC-BY 2.0)

It's by investing in companies listed on the stock market that we'll get the inflation-beating returns we're looking for. But wait, aren't stocks "risky"? The short answer is No. The longer answer needs us to define what we mean by "risk". In the world of investing, risk is related to the probability that your investment will lose value. Okay, we probably agree on that definition. But how can I say that the stock market is not risky if a company that you're invested in can go bust and lose it's entire value?

Let's be clear at this point. It is entirely possible to lose money in the stock market if you invest in any of the following ways:

1. Investing for the short term. Investing now and expecting to cash in on your investment within a very short time period. At any particular moment your investment might experience a temporary (but possibly very large) dip in value despite the fact that it is growing overall. You don't want to be forced to withdraw it during the dip.
2. Investing in a small number of companies and tying the fate of your investment to those few companies. Those companies might die a horrible death, in which case your investment has gone down the tubes. Don't invest in a company based on "a hot tip" from a friend or because the media is going crazy about it.
3. Trying to time the market by "buying low and selling high". This is a nice idea in principle, but it's impossible to consistently get this timing right. Regular people are not soothsayers or stock market geniuses.

So how do we invest in the stock market and reduce the above risk?

1. Invest for the long term - minimum 10 years.
2. Invest in a large number of companies - this is called diversification. If one company goes bust you still have money in all the other companies working for you.
3. Don't try to time the market. Invest regularly and consistently. It's not about timing the market, it's about time in the market.

At this point I think it's really important that you get a decent level of understanding of the stock market before you start investing. One of the Overseas Masters, jlcollinsnh, has done a wonderfully readable explanation of investing in the stock market. He writes from the perspective of the US stock market, but most of what he says can be applied to the South African stock market as well.

We're nearly at the point where we can start looking at specific places to invest your money in South Africa. But it really is important for you to feel comfortable and confident when it comes to investing the money that you have saved through Pillar 1 - this is why all this background has had to come before the specifics.

Until next time!

The Chronicles of our Quest! towards Financial Independence

Dear Awesome Person

Welcome to the first post of The Cent(ri) Frugal Force!

My wife and I are on a Quest towards Financial Independence and this blog is a place for us to chronicle that journey. Financial Independence is not the Holy Grail, but it is something for us to aim towards and keep us focussed. The quest itself is the fun part. Through it we are learning a wonderful new way to live and think about life.

So what is Financial Independence?
Firstly, it's not actually about money...

It's about freedom. 

Photo credit Oliver Berghold (Public Domain)

Freedom to choose what work you do. Freedom to work part-time, for free for an NGO or not at all. Freedom to work because you want to and not because you have to. Freedom to spend time with your children (we don't have any yet, but this is a big motivator for us).

So where does money come into it? It turns out that although money can't buy happiness it can buy some or all of the above freedoms. Here's the slightly mind-bending part. Money can be used to buy freedom by not spending it. If this doesn't make sense to you then I hope this concept becomes clearer through future posts.

Standing on the Shoulders of Giants
Much of what I have learned about managing our family's personal finances is from Overseas Masters which I started following in the middle of 2013. I was already frugally minded before I began reading personal finance blogs on financial independence and early retirement, but these writers have served to validate and incubate my early thoughts as well as give rise to new ones.

Mr. Money Mustache, The Mad Fientist, jlcollinsnh and Early Retirement Extreme are great storehouses of information on living frugally, investing and the journey towards financial independence.

Financial Independence in South Africa

 Photo credit Lollie-Pop (CC-BY 2.0)

I also have read (and still read) some personal finance sites more relevant to our South African context. IOL Personal Finance, MoneyWeb and Maya on Money are some of these websites. The forums on My Broadband are also a really useful place to ask questions, answer questions or even to simply observe conversations that unfold in some of the threads.

The websites that I've just mentioned are useful, but for the most part they are far too tame. They generally tend to assume that the readers are aiming to retire at 65 by saving 10% of their incomes. Now this might be fine if you really love your job and you want to work until you're 65. But if you're like me and you're a little more ambitious (okay, a lot more ambitious) and you want the ability to be free decades before normal retirement age then these resources just aren't going to cut it. The Overseas Masters are really good and most of what they have to say is general and can be applied anywhere in the world, but some aspects of living in a specific place require specific tactics. So sharp as they are, the overseas masters don't quite cut it either.

This is where I hope this blog can fill a gap. I've done quite a lot of research on how things are in South Africa and this blog is an opportunity to share that research with a wider audience than my wife. I don't have all the answers so I'm hoping for lots of comments from and interesting discussions with readers.

Onwards, to Freedom!