To Be Great with Money, You Must Master the Basics

It starts with the most basic concept in personal finance

Success is neither magical nor mysterious. Success is the natural consequence of consistently applying the basic fundamentals.

— Jim Rohn

When I was in grad school studying economics, we had a guest speaker who was an alumnus from the University I was attending who was a big-shot economist at one of Canada’s top banks.

The only thing I remember from that day was during the Q&A session, one of my classmates asked him what was the most important economic concept he learned during school that was most helpful in his career as an economist.

He answered: “Supply and demand.”

I recall my 23-year-old self rolling my eyes at that. Supply and demand is what you learn on day one of Econ 101 in undergrad. Surely, the advanced formulas in grad school econometrics or game theory must be more useful. After all, these are much more complicated, and few people have these tools in their toolbelt.

At the time I write this, I am 10 years into my career as an economist, and if I were asked which economic concept has been most useful, I might very well answer supply and demand.

Mastering basic — but essential — concepts that you use every day will get you further in life than knowing advanced strategies that few people know — but are hardly ever needed in the real world.

In every arena of life, to be great, you need to master the basics.

Budgeting is the most basic concept in personal finance

It’s also one of the most important.

A 2019 survey measuring the financial capabilities of Canadians found that those who use a budget are in a much stronger financial position than those who don’t.

• Budgeters are half as likely as non-budgeters to fall behind on their bills and debt payments.
• 18% of budgeters spend more than they earn, compared to 29% of non-budgeters.
• 31% of budgeters use credit cards and other forms of debt to cover day-to-day expenses, compared to 42% of non-budgeters.
• 35% of people who use a budget make additional payments to pay off their mortgage quickly compared to 24% of non-budgeters.
• 57% of budgeters take action to pay down their other forms of debt quickly compared to 47% of non-budgeters.

Given all these statistics, it should be no surprise that budgeters felt less stressed about money and less time-crunched than non-budgeters.

A budget is simply a declaration of your financial priorities.

My friends and family know I write about finance and money, so they are often eager to talk to me about money. Many of them tell me that traveling is very important to them — but very few of them set aside money every month to pay for future travel costs.

If you say you love to travel but don’t have a line item for travel in your budget — it’s not a priority; it’s a pipe dream. Anything you want to have or do that requires money should be in your budget.

A boilerplate budget that millions of people have used

If you type “budgeting rule” into Google, almost every article on the first page will recommend the same budget template known as the ‘50/30/20 rule.’

According to the 50/30/20 rule, here’s how you budget your money:

• 50% on needs — necessities like housing, groceries, and transportation.
• 30% on wants — variable spending like on entertainment and travel.
• 20% goes to savings and debt repayment.

In the last post in the Dollars & Decades series, I discussed the importance of tracking your spending and evaluating whether you are happy with where your money goes each month.

Tracking your spending is a helpful exercise before creating a budget because it lets you get an idea of how close you are to your ideal budget before making any changes to your spending habits.

But, tracking your spending is most valuable in the first several months after creating a budget. A budget is a “soft commitment” — nothing or no one is forcing you to stick to your budget. That’s your job, and tracking your spending is how you ensure your actual spending lines up with your budget.

Like every rule of thumb, the 50/30/20 rule simplifies a complex issue — in this case, how to budget your money. But there is nothing magical about this allocation — you need to adjust your budget to match your preferences and your current economic reality.

If money is tight, you might be forced to spend more than 50% of your take-home pay on needs. As your financial situation improves, you can allocate more towards savings and wants.

When cutting expenses, work big to small.

Many best-selling personal finance authors make you feel like a failure with money if you buy a latte or go out to dinner.

This kind of small, variable spending is a perfect example of a low Return On Investment (ROI) issue that does not deserve (much) of your attention.

These are small purchases that happen every day.

Remember that attention is a finite resource.

Dedicating your attention every single day to a $3 problem like a cup of coffee is a quick way to burn through our attention. It’s not that these expenses don’t add up or that you shouldn’t worry about them — but most people would be better served prioritizing high ROI spending issues before moving on to the small purchases.

A high ROI issue to focus on is your fixed and recurring spending.

Examples include:

• Housing costs
• Transportation costs
• Internet
• Cell phone
• Gym memberships
• Netflix and all other subscription costs

There are two reasons why fixed and recurring expenses deserve your attention:

1. This is where the lion’s share of your money goes.
2. Cutting these costs requires a one-time investment of your attention.

That second point is critical to understand.

Let’s say you cut out $350 in recurring or fixed expenses. That likely required a lot of your attention to track and prioritize your spending and find places to make cuts.

But, once you’ve made that upfront investment, you continue saving $350 every month without investing another second of your attention on the issue.

Compare that to focusing your attention on cutting out your daily latte. That requires your attention every single day to save yourself $3-$5.

By focusing on fixed and recurring spending, you invest your attention once and reap the financial rewards every month going forward.

Once you make the initial investment of your attention and cut your fixed and recurring expenses to where you want them, then it makes sense to review your small, daily purchases to ensure they are within reason — but as a rule of thumb, focus on your fixed costs first.

When it comes time to focus on your small variable spending, the goal should be to cut out your impulse buys, which are purchases you never intended to make and provide no value.

Think of the $15 magazine you throw in your cart while waiting in line at the grocery store checkout. You went to the store to buy groceries — not a magazine — and odds are you read less than half the articles in the magazine.

It’s worth noting that impulse buys are a specific and harmful subsection of your variable spending or ‘wants.’ If you are a coffee lover, buying your daily latte should not be considered an impulse buy but a deliberate use of money to buy something you enjoy.

When cutting expenses, work big to small and practice mindful spending.

The sneaky expenses that kill most budgets

A 2012 study identified why so many generic budgets fall apart when used in real life:

We vastly underestimate how often and how much we spend money on “one time” purchases that aren’t accounted for in our budget.

The paper’s opening paragraph gives concrete examples of spending that we tell ourselves is rare and worth splurging on.

• Your favorite musician is in town for one night only, and tickets are $500. So, you buy two tickets even though your monthly entertainment budget is $250.
• Next month is your 1st/5th/10th/20th/25th/50th wedding anniversary, and you and your spouse want to celebrate with a 5-star vacation that costs three years’ worth of budgeted spending on travel.
• Your phone dies — or, more likely, is just out of date — and you spend $750 to buy a new one. The problem? You budget $100 monthly for your cell phone bill but don’t include the cost of replacing that phone every two years.
• Your inlaws are staying at your house for a week over the holidays, so you need to stock up on additional groceries and alcohol.

You tell yourself that these are all “exceptional circumstances,” so even though you haven’t budgeted for these expensive events, it’s okay because “you’re not going to make a habit of it.”

Except, you are going to make a habit of it.

While it may be true that any one of these expenses is unlikely to repeat itself anytime soon, there is always another exceptional circumstance that will require you to spend more money.

That’s just life. Random events are always happening that don’t fit neatly into a generic budget template.

If you base your financial plan around the 50/30/20 budget, your financial future relies on the idea that you will save and invest 20% of your income, which is easy enough to do on paper.

But when you fail to budget for these “one-time” expenses like the $750 to buy a new phone, that money has to come from somewhere. It might mean cutting back on spending in other areas, but let’s be honest; it often means saving less money.

What happens if your budget allocates 20% of your income to saving, but after paying for various “one-off” expenses throughout the year, you only save 10%?

For a 30-year-old, clearing $50,000 per year after taxes, a savings rate of 10% instead of 20% adds up to $367,671 less money saved by the time they are 65 — assuming only a 4% average return on their savings and investments. The higher you assume your return on savings/investments, the greater the shortfall in final expected savings.

Why does it matter?

Saving less than half of what you planned for means delaying retirement, working part-time in retirement, reducing your standard of living in retirement — or some combination of these three options.

A budget you stick to is a powerful tool — a budget you don’t stick to can trick you into thinking your finances are stronger than they really are.

How to budget for “one-time” expenses

Budgeting is simply an act of what economists call “mental accounting.”

Mental accounting refers to how people organize their financial lives by operating their savings, investments, and spending into different categories, each serving a different purpose.

Often, these different categories are divided into separate accounts, such as;

• Emergency fund
• Retirement fund
• Vacation fund
• House repair fund
• Car repair fund
• Kids education fund
• Accounts to cover healthcare costs

These are typical examples of using mental accounting to segregate our money from one big pile in our checking account into smaller piles, each earmarked for a specific purpose.

Mental accounting is helpful for expenses that remain top of mind, like groceries.

We make up a rule that we will spend $500 per month on groceries. As a result, when shopping, we are very aware of how much we spend. But when we have a “one-time” expense like hosting a dinner party, we are more likely to overspend because we don’t view that exceptional spending as part of our general grocery budget.

The research shows that most people can use mental accounting to accurately forecast these “normal expenses” but fail miserably at forecasting the “one-time” expenses like buying a new phone or concert tickets.

One-time expenses are difficult to categorize and don’t fit neatly into our mental accounts, aka our budget.

This also explains why we never learn from our mistakes; we always face one-time purchases but never include a line item for these expenses in our budget.

If an item doesn’t fit into one of our narrowly defined budget categories, we deem it unimportant and ignore it, causing us to spend more and save less than we planned.

The researchers of the study I referenced above found that budgeters spent less money on “one-off expenses” when they were reminded about how often these “one-time” expenses come up while creating their budget.

They use birthday presents as an example.

Participants in the study were split into two groups. Each group was assigned the hypothetical task of buying a watch for their friend’s birthday.

Group 1 was given the additional context for their task:

“In the space below, please list the times last year when you gave people presents. For example, a friend’s birthday, an anniversary, or a holiday.”

This simple task forced people to stop thinking of the cost of giving gifts as a “one-off” expense but as a recurring expense. This subtle reminder that giving gifts is not as rare as we think caused people to spend 16% less on a watch for their friend’s birthday. There needs to be money left over for your anniversary and holiday gifts!

If you don’t have a line item in your budget for gift-giving, the natural tendency is to think of these as one-off purchases and simply go over budget. You don’t see this as a problem because it’s a “one-time expense,” but as different one-time expenses add up, you consistently overspend your budget and fall behind on your financial goals.

The way to stop overspending on one-off expenses is to remind yourself that there is no such as thing as a one-off expense.

The lower-effort way to do this is to remind yourself that these expenses are not as rare as you think.

Next time you host your inlaws for a week over the holidays, ask yourself, “How many times in the past year have we hosted people for meals at our home?” That includes dinner parties, birthday parties, backyard BBQs, and holidays. Reframing these “one-off” purchases as part of a regular spending category means you’ll spend less.

Do you need to buy the $75 bottle of wine to impress your father-in-law? Remind yourself that you are hosting a dinner party next month, so you can’t spend too much right now. Your father-in-law will survive if you buy the $10 bottle.

If you want to go the extra mile, you can create new line items for these exceptional expenses in your budget.

Here are a few examples:

• A sub-category under groceries could be “hosting” expenses, where you allocate money for hosting friends and family for special events.
• A sub-category under your cellphone accounts for the fact that you buy a new phone every two to three years.
• A line item that reads “bucket list” plans for the fact that sometimes you will do seemingly crazy things like spend $750 on a Taylor Swift concert because it might be the only time you get to see her live.

It’s not a financial crime to spend big on special occasions.

But, if your budget is to be of any use, it needs to accurately reflect how you spend your money. Reframe every “one-time” expense as part of a broader category in your budget and remind yourself that the next “one-time” expense is just around the corner.

The simplest way to stick to your budget? Automate as much as possible

I’ll repeat this because you can’t afford to forget it; you are the only person who can force you to stick to your budget.

Budgets are like fitness plans — they are easy to start, but few people stick with them past the first month.

The good news is that, unlike fitness plans, much of the work of budgeting can be automated.

Most of your bill payments, recurring expenses, debt payments, and savings goals can be automated — meaning the money is automatically taken from your checking account and used to pay a bill, make a debt payment, or moved to a savings account.

The more line items you automate in your budget, the fewer times you need to make an active decision to stick to your budget.

When automating your savings and expenses, leaving a buffer in your checking account is important. You’ll get hit with penalties and overdraft charges if you don’t have enough cash in your account when an automatic bill payment is due. Leaving an extra cushion of cash in your checking account can help reduce the stress many people feel when automating their budget.

Automating your finances removes human error and is a powerful tool to ensure you stick to your budget in the long run.

A version of this story was originally published on the Making of a Millionaire Substack, the home of my writing. As a thanks for reading my work, existing readers can get 75% off their first year’s subscription here.

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.