Back to Basics: Making a Budget
In the previous post to this “Back to Basics” series, I talked about how millennials making $2,500 a month should allocate their paycheck.
To summarize, they should mentally divide their paycheck into three equal parts (~33% each):
- Rent and Bills Fund ($833)
- “Present Me” Fund ($833)
- “Future Me” Fund ($833)
Another way of thinking about this is:
- My overhead (i.e. fixed costs)
- My short term needs (i.e. money I need within 12-18 months)
- My long term wants (i.e. money I need beyond 18 months)
This is how things should look in the perfect world. Unfortunately, saying that the world is not perfect might be the understatement of the century. Most people aren’t even remotely rational or sane.
In 2018, the U.S. personal savings rate is 2.8% - a historic low. This is partly a symptom of our two-tiered economy where the rewards disproportionately benefit the top 40%, while technology and trade outflows decimate the bottom 60%.
The other part is people feeling too pleased and comfortable with themselves.
It’s been almost a decade since the last recession. We are now in the longest bull market in post WW2 history, where the value of most assets have been rising (eg. stocks, real estate, bonds), while consumer prices have been falling (eg. Amazon, airline tickets). “Dumb money” has entered the market in droves, peaking in December 2017 when cryptocurrencies hit their record highs. “FAANG” stocks are now being priced for perfection. Nothing could possibly go wrong, right?
This is my opinion, but there’s no better or more urgent time to start thinking about making a budget than times like these. In a market economy, rewards often go to the few at the expense of the many, because the many are typically unwilling (or unable) to take short term pain for long term gain.
Or to quote Warren Buffett: “Be greedy when others are fearful and be fearful when others are greedy.”
Making A Budget: What is a Budget?
A budget is the marriage between our aspirations and reality. It’s also an expression of our priorities. People in project management probably know this diagram:
Since resources are limited: fast and cheap won’t be good, cheap and good won’t be fast, good and fast won’t be cheap.
The same concept applies to your budget and paycheck.
Out of your financial needs, you should prioritize two:
- Overhead (Rent & Bills)
- Short term needs (Present Self)
- Long term wants (Future Self).
With the average millennial’s $2,500 a month after-tax paycheck:
- High overhead and short term needs means punting on your debt and retirement and letting interest accumulate into your midlife
- High short term needs and long term wants means living in an undersized apartment in an undesirable neighborhood (or even city)
- High overhead and long term wants means living on cheap groceries and never eating out, traveling or shopping.
Now pick one.
The Fairness Argument: Millennials, Baby Boomers and Their Finances
Jennie and I have seen the panic in peoples’ eyes at the mere mention of a budget. The conversation usually starts off with a question:
How can you afford to quit your 9 to 5 and travel around the world for over a year?
Our answer: a combination of privilege and having a budget that prioritizes a few things for a long period of time. Specifically, we keep our overhead way below what most are comfortable with, so that we can save for our long term wants without sacrificing the small pleasures that keep us going day to day.
For example, before we “graduated” to our $1,395 a month studio apartment in West Los Angeles, Jennie spent years renting a closet-sized room on the outskirts of Boston for $450 a month, while Ivan paid $650 a month (Canadian dollars) for a basement unit on the outskirts of Toronto. We made these short-term sacrifices by choice.
At this point, we usually get one of two responses:
- Denial: “I could never do that. That’s just not who I am.”
- Blame: “You’re privileged and definitely not the norm. Our system is rigged to benefit the top 1%. The most important thing is to fix the system instead of putting unrealistic expectations on ourselves.”
Jennie and I have had variations of these conversations with fellow millennials over the past two years. We empathize with these feelings because they’re based on kernels of truth.
But there’s a difference between what feels popular, good or just (i.e. the right thing to say) with what’s rational and productive (i.e. changing with the facts).
Looking through the windshield, millennials have it tough. Looking at the rearview mirror, baby boomers have had it easy. But it’s also true that everything looks easy with hindsight. The road ahead always looks dark and uncertain- for every generation, in every time period.
Expecting to achieve the same results as our parents by doing the exact same things they did defies basic laws of markets and evolution.
The Biggest Misconception about Making a Budget
The biggest misconception people have about budgeting is that having one means denying yourself everything.
This may be true for people making under $37,000 a year, which according to MIT’s living wage index, is the minimum salary a single adult needs to live in San Francisco, the most expensive city in the country.
But not all of us live in San Francisco. And if you’re above the $37,000 threshold, having a budget is not only a realistic option, but a necessary one.
To say that a budget means denying yourself everything, we first have to agree on what “everything” means. Does “everything” include vacations to foreign countries? Drinking and dining out a few times a week? High-end gym memberships and yoga classes? Personalized chauffeurs that drive us to and from bars (Lyft/Uber)? Does “everything” include a cleaning lady (this is real. we’ve seen this) that comes twice a week to tidy up our one bedroom apartment?
Where does “everything” begin and where does it end?
And that’s what a budget is for: to draw a line between our aspirations and reality.
By and large, millennials want a luxurious life, for a less than luxurious price, before we can realistically afford it. Because “everything” was what we’d imagined we’d be getting when we became adults.
Ironically, sacrificing short term gratification for long term goals through a budget, is the most “adult” thing I can think of.
3 Tradeoffs We Made With Our Budget
Let’s bring it back to our hypothetical millennial. $40,000 salary, $40,000 in student loans, $2,500 a month paycheck, divided into three funds in the “ideal world”:
- Rent and Bills Fund ($833)
- “Present Me” Fund ($833)
- “Future Me” Fund ($833)
Here are three ways Jennie and I approached this problem in the real world:
1. Underspend on overhead: keep rent & bills to
less than 30% of our after tax paycheck.
This means at a $2,500 monthly paycheck, around $650 was allocated to rent and bills. And we’re not talking hypotheticals here:
- In 2014, Jennie made $42,000 a year. As recently as 2014, Jennie’s salary was $42,000 in a high cost of living city (Boston). She paid $450 per month for rent & bills to stay in a closet-sized room in a house shared with two other roommates.
- In 2012, I made $58,000 CAD. My starting salary in 2012 was $58,000 (CAD), paying $650 per month in rent on the outskirts of Toronto, while my peers rented one bedroom apartments in the downtown financial district. We were consultants, usually traveling four days a week, and were rarely home.
If we had had $40,000 in student loans, we would’ve paid it off aggressively within three years. Instead, the extra savings went directly into our fuck-off fund and retirement. No debt and a fuck off fund allowed us to swing for the fences in terms of raises and higher paying jobs. Higher earnings in turn, funded our fuck-off fund, retirement and other long term goals. A virtuous cycle begins and gains momentum (this happens much quicker than you think). Meanwhile, our overhead stayed fixed on one year leases.
2. Underspend on depreciating items in favor of value add experiences
Jennie gave away her car to family and started taking the bus. The total cost of all the furniture in our home is under $1,000. We don’t have the latest technology in our home or in our pocket. We make little to no new clothing purchases outside of travel gear, clothes which will eventually have to fit into 40L backpacks.
In return, we traveled across America by Amtrak rail, held our wedding in Taiwan, honeymooned in Okinawa, attended the jazz festival in New Orleans, made business contacts in San Francisco, camped in Death Valley and Joshua Tree, spent quality time with family and friends in Taipei, Albuquerque, Denver, Boston, and San Diego.
For us, the small adjustments meant bigger returns on experiences that we love so much.
3. Planning months (or years) ahead for large purchases
so we don’t have to deny ourselves small ones
Our dirty secret: we divide the cost of large purchases across multiple months to absorb the impact.
We never mentioned this explicitly in our money diary, but we bought a $1,000 camera last year in July 2017 to bring on our RTW trip. Using an accounting gimmick, I divided that expense into two $500 items, and logged them in our budget under “Education & Investments” in July 2017 and August 2017. This “smoothed” out our spending, but more importantly, we did it because Jennie and I had already planned out this purchase eight months in advance - so we “freed up” $500 in the budgets of July and August to absorb it.
In return for long term planning for large purchases, we never have to deny ourselves smaller ones. Whenever we have a craving: for tacos, chocolate, a fizzy drink, coffee, donuts, macarons, bubble tea, the occasional take-out etc, we never have to “check our budget” to see if we can afford it. Even if we go slightly over-budget in some months, who cares? Buy it, log it, and move on. Micromanaging small transactions wastes precious time and headspace - and it really isn’t our style.
Finding Your Budget Sweet Spot
There are many variations to a budget that can be tailored to the things and experiences that matter to you. Jennie and I aren’t saying that our way is the “right” way.
But the common thread of all budgets is that something's got to give. And if you sweat the big, uncomfortable things (you know, the material things we tie unnecessarily to our self esteem and identity), the small things take care of themselves.
In our case, we said to ourselves: "fuck paying overhead and let’s live for the now and for the future. If we have to live in squalid surroundings or tight studio apartments, then so be it. At least we'll have each other."
That was more than we could’ve hoped for after six years of long distance.
After reading this, some might be disappointed that I haven’t provided any answers on “what to do.” Fortunately, that’s not the point of this series. Nobody can tell you what to do, or convince you to do something you’re not ready for. Money is less a math problem, but an emotional & psychological one.
The only thing we can control is an awareness and understanding of each trade-off we make. We need to construct a budget that takes into account those trade-offs: between overhead, our present self and our future self. Finally, we need to ask ourselves whether we can learn to live with the end result.
Because perfection is the enemy of the good.