Personal Finance Education Series: (3) It All Starts with Saving

I thought it was important to dedicate a chapter to probably the most fundamental basis for any great personal finance & investing plan: saving.   The truth is, without a strong desire and dedication to saving, the rest is just decoration.

Saving, at least in this context, has a very specific meaning.  It means spending less than your income on a consistent basis.

It sounds easier than it is, however.  We live in a society that completely surrounds people with millions of things that they can’t afford, but that are sold to them as if they must have them.  Peer pressure makes this worse, because in our society you get to publicly see people’s possessions (cars, houses, gadgets) and not their bank statements.  As a result, the people who have spent the most money on publicly visible things look the wealthiest, even if they are up to their eyeballs in debt.

Don’t confuse having a lot of financial assets with saving.  The average baby boomer has $52,000 in their 401(k), but also has thousands of dollars in credit card debt.  It is very easy to fall into the trap of using debt from credit cards to cover expenses, and then feel like your saving by contributing to a college fund or a 401(k).   In the end, that debt will catch up to you.  In most situations, saving means covering all of your expenses with your income, and then having money left over.

I’ve spent some time on this blog talking about behavioral finance, and some of the ways that people are irrational with money.  As a result, I thought I’d point out at least a couple of popular ways that people seem to find ways to consistently spend less than they make.  Please feel free to share your own techniques below in the comments.

The first way is to always focus on value, and to begrudging spend regardless of income.  If you were fortunate enough to grow up with grandparents who lived through the Great Depression, you likely are familiar with this approach.  Many people are often suprised to find out how many wealthy people, who don’t need to worry about spending an extra $10 for dinner, actually fit into this category.

This approach may seem miserly to some, but it’s not always unhealthy.  In fact, at its heart, this approach focuses on the basic fact that very few things, in fact, are “needs” vs. “wants”.  You may have the extra $20,000 to buy a luxury car, but do you really need it?  Isn’t there something else you’d rather spend that money on?

The problem with this approach, of course, is that taken to the extreme, it can lead people to save everything, and enjoy nothing.  Every now and again, you hear about the old widow who left $20 Million to a University, even though she lived with no heat and ate oatmeal every day.  Sad, really.

The reason this approach does work for many people, however, is that typically if you are judicious about all of your spending, you regularly will avoid an awful lot of impulse buying.  In general, like in dieting, it’s the impulse spending that really does in many people’s budgets.  Things that feel like “needs”, but really are “wants”.

While I’d like to think that I’m judicious about spending, I’ve never been able to make the first approach really work for me.  I believe in saving, but I also believe in spending to an extent to enjoy life with your family.  That leads me to the second approach.

The second approach is a form of strict mental accounting.  The idea here is to have a strong understanding of your income, and dedicate fixed percentages of it to different savings goals.  This approach has been put into practice extensively in the past twenty years for 401(k)s, but can be used for almost any savings goal.

In order to make this approach workable, many people find that they need to make it a little stronger than a mental promise to put money away.  To give it teeth, people now use automatic deductions from their paychecks or bank accounts, to help siphon money away before it’s spent.

Some companies will let you do this with your paycheck.  If your company doesn’t, most online banking services will let you set up monthly (or even weekly) withdrawals.  You can easily set up automatic withdrawals to fund savings accounts, retirement accounts, college savings accounts, health care accounts, and dependent care accounts, just to name a few.

In fact, the reason that owning real estate often works well for most people is that in can be thought of as a forced savings plan, with a certain amount every month going to principal.

If you fit into the category of someone who really want to get a handle on their personal finances, make sure that you are set up for success on an ongoing basis.   The easiest way to do this is to produce a quick Income Statement for yourself.

It’s really fairly easy.  Start by looking over past bills, credit cards, bank statements, and paychecks.  Make a quick tally, say for the last three months, of:

  • Income (Salary, Gifts, etc)
  • Expenses (Mortgage, Utilities, Dining, Groceries, etc)
  • Saving (401(k), ESPP, college, etc)

All of your income went somewhere, so it’s important to tally up how much you spent, and how much you saved.  Don’t be surprised if, in fact, your “saving” and “expenses” add up to more than your income.  What that probably means is that some money effectively came out of your bank accounts, and went to fund something else (hopefully another savings vehicle, like a 401(k), and not a new dining room table).
Most personal finance magazines recommend that people save around 10-15% of their income, but the actual number will vary depending on your income, your circumstances, and your goals.  Obviously, the higher percentage of your salary you save, the quicker your assets will grow.   As a regular reader of magazines like Money & Smart Money, you’ll often read about people who save 20, 30, even 40% of their income by living frugally.  There is no right answer.

When you start crunching the numbers for goals like buying a home, saving for college & funding retirement, you start realizing that it takes a fairly large percentage of your salary to achieve those goals in the time frames that make sense.   As a result, 10-15% seems to be a sweet spot in terms of balancing short term needs with long term goals.  Personally, I recommend that people not pick a single magic number, but instead really think through their different long term goals, and then pick a number for each that will actually lead to success for those goals.

Once you have your savings plan in place, then the next step is to start breaking up the money across your different goals.  In my next post, I’m going to talk a little bit about one savings goal that often goes overlooked, and yet is likely the single most important goal of all – the emergency fund.

6 thoughts on “Personal Finance Education Series: (3) It All Starts with Saving

  1. I use method one with a slight modification. I alway like to figure out my options when it comes to spending. Instead of “need” vs. “want”, I use basic, good, better, and best. I figure out how important is something to me and my family then I would spend to match the importance. For example, a car is not important to me. I buy the most basic, best mileage, and reliable car. I’m still driving the same car after 13 years. Vacation is important to me. I would spend the extra to get the ocean view room. It’s a bit more balanced although most people still think I’m frugal.

    Other savings methods that I use
    1) avoid regular / month expense. Many companies does automatic deduction from checking account, etc. I never sign up for them.

    2) make a goal to cut your expenses by 5% every year. It’s actually not very difficult. Every Jan I review all my bills from the year before and call up all the vendors and ask them about promotion, and discounts for regular customers. Review my credit card, insurance, cable, internet, etc. Do a little bit of comparision shopping. You be surprised how much you can save with just a few phone call.

    3) Do your own taxes or at least understand everything that your accountant is doing. For me after mortgage, taxes often is my 2nd biggest expense. I alway do my taxes twice. I do it once and my accountant does it again then I ask about every disprecancy and understand the difference. Managing my tax liability has help improve my savings rate.

    The next two ideas are not directly saving method but it’s important to build a habit for saving.

    3) Talk about money! In my family and with close friends we regularly share ideas about where to get the best interest rate, tax strategies, saving strategies, etc.

    4) Choose your friends and associates wisely. If you hang out with spenders you are going to be less careful with your money. Hang out with saver, then it’s easier to save your money.

    Great article. looking forward to the next one.

  2. You said:

    “Every now and again, you hear about the old widow who left $20 Million to a University, even though she lived with no heat and ate oatmeal every day. Sad, really.”

    You know, I live with no air-conditioning, and eat oatmeal everyday…it’s really not that bad…

  3. Pingback: Psychohistory Personal Finance Education Series: (5) Diversification & Asset Allocation «

  4. Hi Adam, just found these posts via your feed today. nice work!

    Wanted to share my top 2 tips for saving money:

    1. stop going out to eat and carry your lunch. When I stopped eating out for dinner and started taking my lunch to work, I found I could afford to eat really high quality food from Whole Foods, at nearly 1/5th cost of my old life style. Bonus: I’ve lost weight because I’m not eating all the excess calories that are served in huge, high fat portions in restaurants. Double Bonus: it’s been great for the relationship to cook together each night.

    2. Shorten the commute. I discovered when I was commuting from SF to San Jose, I was spending 24k PRETAX to commute in depreciation, parking, gas, maintenence, etc. Let me repeat that, I could afford to take a pay cut by stopping the commute. I now walk to work. I still might sell my car, use zip car instead, and save another $500 a month!

    I had created a six month efund and paid off all short term debt after only six months of these 2 changes in my life. Now all that’s left is the student loans and I am whacking away at the high interest ones first, then it will be time for serious investing.

    And lastly, some philosophy: I had a professor in b school who used to refer to the e fund as the “go to hell fund.” He showed us a study of Harvard MBAs who had been faced with an ethical challenge. The people most likely to make unethical decisions were the ones with no financial cushion. The Go to Hell fund enables you as a manager to simply walk away when a company isn’t furthering your professional growth, or tempting you to cross an ethical line, or putting you in a position to compromise your values.

    Saving my money that I’ve earned with my time, which is my most precious possession = personal freedom! I just wish it hadn’t taken me 35 years to learn this!

  5. Hi Melinda,

    Glad you found these posts! Your advice is really well taken – most people don’t every really sit down and evaluate how much they spend on the basics.

    The comment on the ethical implications of not having an emergency fund is very interesting. There is no question that being tapped out limits your options, and could definitely put someone in a corner where desperation takes over.


  6. Great suggestions. My wife and I are in the process of eliminating our debt as well.

    One of our savings schemes is to pay off our car loan in a couple of years and then continue to make the payment to ourselves with interest until we’ve saved the equivelent of what we paid for it over the term of the loan. The next car we will buy outright and pocket the interest we would have paid on a new loan. With our last vehicle we got huge discounts and incentives buy buying the previous year model that had been sitting on the lot costing the dealer money. They make these deals with the hope of making up the discounts with the financing. Buy paying cash we’ve estimated that the potencial savings between the discounts and the future interest we will continue to pay ourselves in interest berring accounts will be in the tens of thousands of dollors. That is more than enough to cover the registration and required insurance while still getting to enjoy a newer car. Why give all that money to the finance company. Basicly we want to be our own bankers.

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