Wednesday, December 18, 2013

The 60% Solution to Budgeting

There are a number of subjects that fascinate me because there are no one size fits all solution. One is the never ending search for the portfolio for all seasons. Of course I understand there is no such thing. All model portfolios break down under some condition. However, thankfully, there are a number of model portfolios that work very well, at least most of the time. Another of these subjects is the monthly budget. Ultimately, we all have to live on a budget. Our money is a finite resource. Unfortunately nobody wants to live on a budget. When the financial class is over; when the emergency is resolved; the formal monthly budget goes out the window.

It is important that you live on a conscious monthly budget that is appropriate for your situation. The lowest level of rigor is the net worth method. Everyone should do this every month at a minimum. Calculate your net worth on the first of every month. If it is going up at an acceptable rate, everything is fine and dandy. If it is going down, ask why. If we are honest and reasonably disciplined it is pretty likely we know why. Perhaps the car required a costly repair. Perhaps you were hit with your annual property tax.

If you don’t know why institute the next level. Keep a detailed record of everything you spend over the next month, to the penny. No excuses. List every expense under the appropriate category on a piece of paper or on a spread sheet. This is enough of a pain that it will tend to lower your expenses. If you list that $5.00 cup of coffee, not only do you have to write it down, you have to explain it to yourself or worse yet, your spouse. I did this twice during the early years of our marriage. It really works.

The full formal budget remains the gold standard. There is no doubt that you will do better if you use it. Unfortunately, not very many people live on a formal budget, at least not for very long.

Richard Jenkins proposes the 60% solution as a sound method of budgeting that is actually easy to practice. The goal is to live on 60% of your gross income. This money covers the basics food, clothing, essential household expenses, insurance, charity, all bills (including nonessentials like music lessons for the kids or cable TV), and taxes.

The remaining 40% is divided up in priority order as follows:

1)10% Retirement. In the author’s case, this all went into his 401K.

2)10% Long term savings. This amount should be automatically deducted from your pay. You should never see it. It should be relatively illiquid. If it takes a little work and a couple of days to get at this money you are less likely to use it.

3)10% Short term savings for irregular but somewhat predictable expenses such as Christmas, vacations, car repair, and new appliances. This money should be held is something like a money market fund that makes it easy to spend when it is needed.

4)10% Fun money. This money can be wasted on whatever suits your fancy. Maybe you might want to think about a pink checkbook for the wife and a blue checkbook for the husband for this one.

The author admits that this method will not work in every case because more than 60% of your gross income is already spent at the beginning of the month. He suggests four possible causes that might need to be addressed before the 60% solution would work for your family.

• You have a more expensive home than you can afford.
• You have committed to car or boat payments that are larger than you can afford.
• Your children are in a private school that you can't really afford.
• There's just a big, ugly gap between your income and your lifestyle.

If you can not live on 60% of your gross income consider that number a goal. Start where you can start, say 80%. Then work your way to 60%.

Better yet if you can’t live on 60% of your gross, consider the full blown formal monthly budget.

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