Managing your personal finances is likely the most important determinant of whether or not you become wealthy. It's certainly more important than some factors that many Canadians focus on: great investing skills, having a high income, or buying a house as fast as possible to start "building equity".
It might be a symptom of our immediate satisfaction culture, or it might be bad guidance and examples shown by adults from the time we are very young. But the millions of Canadians who bumble along from paycheque to paycheque scraping together a few nickels and dimes here and there for extra expenses are largely victims of their own bad decisions.
We're different here on TRM, so lets state the obvious of why control of spending is extremely important and give you some tips on how to manage your spending while still having fun and dealing with those larger expenses like vacations or home maintenance.
Saving Money is the Foundation
To become wealthy, you must save money. That's really all there is to it; it is the foundation on which everything else is built. It is completely impossible to build your net worth if your spending exceeds your income for any extended period of time. Only once you have accumulated some savings, can you begin putting money to work for you in a more passive manner. Build wealth from your wealth.
Save Your Way to Wealth
I like to save money first. This means putting a healthy portion of every paycheque directly in my investment accounts. Start by filling up your TFSA, your RRSP (unless you have very low income), and finally your non-registered investment account. If you are a couple who works together for a secure financial future, just filling your TFSA accounts is an easy fail-proof way to accumulate significant wealth over time that's completely tax free. If you want to get a bit more technical and tax optimize, you can mix your savings between TFSA and RRSP accounts.
It doesn't take special investing knowledge to grow $500 or $1,000 a month in savings into serious wealth by standard retirement age. With the Vanguard Portfolio ETFs, a simple one-ETF solution that mixes stocks and bonds with three different styles depending on your risk tolerance, you can achieve investment returns of 6% annually over time. For a couple who saves $900 per month, that grows to $1.3 million if you save from the time you're thirty until you are sixty-five. $1.3 million in investments is no joke! That will generate you a safe annual income of $50,000 to $60,000 per year, every year, for the rest of your life.
If you learn a lot about investing and achieve higher returns, you may hit your net worth goals much sooner and you could become very wealthy. However, that doesn't replace saving. Always save a lot and count on moderate returns. Then let those big returns go to work for you, powered by a big savings rate.
Use Monthly Moving Averages to Manage Expenses
To save money successfully and sustainably, you must limit your spending. To help get a better grasp of your spending and savings rates, you should average your monthly income, spending, and savings over several months. This is similar to using a moving average to determine price trends in investing. By smoothing your spending and saving, you can see the impacts over time, make better decisions, and reduce the big swings in spending that can frustrate you.
I believe a very good Rule of Thumb is making sure your Spending does not exceed your Net Income minus Savings over any rolling 6-month time period. This allows some planning for vacations, dining and entertainment, and other extras that shouldn't fit into your regular expenses.
John and June are a married couple who earn a combined $6,000 a month after their taxes and payroll deductions. Their goal is to save 15% of their take-home income every month ($900). Their reoccurring expenses include their mortgage payment ($1,800), property tax ($250), insurance ($300), cell phones ($150), cable ($100), vehicle payment ($400), electric and gas ($300), fuel ($250), and groceries and household supplies for a family of four ($800). This leaves them with $1,650 per month for savings and "extras".
The family is planning a vacation in July, which they do once per year. How much should they spend on that vacation?
Well, we know they want to save $900 per month in their investment accounts. That leaves $750 per month for things like vacations, emergency funds, and entertainment. Over a year, that adds up to $9,000. Smoothed out over 6 months, the family can spend $4,500 on these extras. Since its not wise to spend all of the $4,500 on vacation alone--dining and entertainment is important as well--they might decide to spend $3,000 on their vacation. We'll assume in a regular month, John and June will spend $200 on eating out and other extras, but in December they spend $1,000 to pay for gifts, visiting family, and some fun days.
To help smooth the cost, they could pay for the hotel costs in March ($1,200). Then in May they might start setting aside money in a savings account every month for the remaining vacation spending ($1,800). From this money, they will pay for restaurants, passes for entertainment parks, kayak rentals, or whatever else is on their list of things to do. If they decide to splurge when on vacation, they might decide to stop eating out while at home in May, June, and August to put all that extra money towards their vacation. The family can limit their spending to $50 per month on extras when they are "living on a tight budget".
By thinking about their spending taking into account past months and future months, John and June's spending never exceeds their income over a 6 month period of time. They can average their costs and still keep their spending under control while enjoying their vacation.
Here's how their income compares to their 6-month average spending over a two year period with the $3,000 vacation happening in the second year.
While the monthly expenses (including their $900 savings) exceeded their income in several of the months, when averaged over 6 months, they never had their expenses exceed their income. It always had a cushion ranging from $100 to $450 dollars. This money could be used for entertainment and to fund their emergency accounts. This type of responsible spending makes sure your finances can withstand those expenses that pop up from time to time without diving deeper into debt.
You can quickly make a graph similar to this to keep track of your own monthly income, savings, and expenses with a simple moving average by using Google Sheets or Excel.
Be Careful with Large Asset Purchases
When it comes to income and expense smoothing, you should exclude large one-time asset purchases from your spending. This might include buying a house, or doing a large renovation. It is very easy to over-reach when buying these big assets because their costs, from a cash flow perspective, are broken into relatively small monthly payments. However, these monthly payments can make huge dents in your savings rates. My wife and I chose to go down to one vehicle and rent a smaller rowhouse for exactly this reason. Maxing our free cash flow lets us save over $60,000 per year!
Houses, when purchased at reasonable valuations, typically hold their value roughly in line with inflation over long periods of time. This has been clearly demonstrated with academic research. But you shouldn't be buying if it doesn't make financial sense. Grit your teeth and rent, or move somewhere house prices are more reasonable. Buying overpriced houses will make you poor.
Renovations are a bit tricky to value. The research I've done on this--from back when I was a carpenter and bought and upgraded my own house--suggests you are lucky to add around 75% of your renovation costs in increased value to your home for a typical, frugal renovation. This varies from 90% or higher for simple things like insulation, paint, doors, and mouldings to barely 50% for bathroom or outdoor deck upgrades. Generally speaking, high-end upgrades have a lower return on investment. DIY renovations can increase that return, but only if your work is of professional quality! So, if you do a $10,000 bathroom renovation and upgrade, you can expect your house to increase just $5,000 in value.
To some extent you might exclude vehicles and RVs as well, but you should always buy vehicles with a huge dose of caution. Along with over-priced housing, vehicles are a major source of financial problems. They depreciate rapidly and are expensive to keep on the road.
It's also tricky to conceptualize the true cost of a vehicle when most purchases are financed. Monthly payments of a few hundred bucks can appear a lot more reasonable than cutting a cheque for $30,000 to the dealership. I think it's better to buy used vehicles with cash that you've saved up over time. You can often find good used vehicles just a few years old for half of the new sticker price.
Everything on this blog, and in your personal financial well-being, starts with saving. You need to cut your spending, manage those large expenses, and maintain a consistent surplus over any 6-month periods to put money into those investment accounts. After all, there's absolutely no point in reading about investment strategies and how to maximize your returns while reducing your risk if you've got nothing to invest in the first place.
Investing on its own will never replace the need to save. You should count on obtaining investment returns of approximately 6% per year if you are willing to take on quite a bit of risk. Anything higher than that is a bonus. The difference between investing and obtaining 6% returns and obtaining 12% returns is the difference between becoming rich or super-rich. That's completely different from trying to invest your way to success because you are unwilling to save enough money. Saving the right amount of money first is essential.
Use a spreadsheet application such as Excel or Google Sheets to keep track of your monthly income and expenses. You can keep separate columns for each expense category such as mortgage, groceries, clothing, utilities, and savings. A simple averaging formula can help you track those bigger expenses and make sure you are not in a perpetual deficit spending situation. You also might be amazed at how much money you spend on useless stuff that provides you with no real value.
Watch those large asset purchases. Houses, vehicles, renovations, RVs, boats, and other big purchases should be analyzed very carefully. Nearly everywhere in Canada right now you are better off renting than you are buying a house. Keep in mind that renovations are not as good for your bottom line as they are often promoted to be. Vehicles and toys should be bought used with cash so you don't fall for those monthly payment traps. Monthly payments cut deep into your ability to save money.
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