So, I have not written a ton about personal finance topics on this blog. In my mind, I am kind of holding off on those topics until and unless I am able to accumulate a significant amount of financial assets and reach “financial independence.” If there is an interest in more discussion of these sorts of topics, drop me a comment and I will try and oblige.
A few weeks ago, Daniel Egan who is with Betterment (a robo-advisor) shared a recent post he published on the Betterment blog. By the way, Egan is a good follow on twitter (@daniel_egan). The post was about how he uses lessons from behavioral science to help him manage his personal finances.
The first of the big ideas that he covers is automating savings as much as possible. I use automatic transfers and allocations directly from my paycheck, such as contributions to my 401(k) and other accounts to reduce the temptation to divert funds for other short-term uses. As we have already discussed, many of the reasons for this tactic are discussed in Richard Thaler’s Nudge.
Using the terminology of Daniel Kahneman, we set up the savings and other automatic allocations using the long-term planning function of “System 2” preventing (or at least reducing the likelihood) that the impetuous System 1 will spend that money on new kicks. We make the decisions that are implemented automatically when we are “thinking slow.” In order to divert the money to less important goals, while I am “thinking fast” I try and force myself to jump through some hoops.
I also treat savings as mandatory and spend only the remainder. In order to get a ballpark estimate for these relative allocations of my earnings I increased savings to the “pain point” where I felt deprived of cash and then dialed it back just a bit. I also automatically increase savings by at least 50% of any raises or bonuses each year. I remind myself that if the amounts remained static, I would be saving less each year due to inflation. A good simple book about these concepts is David Bach’s oldie, The Automatic Millionaire. By automating these decisions as much as possible I try to avoid monthly drains on my willpower to stick to long-term goals.
Viewing Saving As Mandatory
A related concept that Daniel discusses, is framing saving as a bill. I don’t do exactly this, but I do try and frame it as a promise and try and prioritize it over discretionary spending. It is really just the old adage of “pay yourself first.” Research has shown that when we make a promise or plan in writing we are less likely to deviate due to impulses. See, Thinking Fast, and Slow. This is one reason why most personal finance people recommend that you have a written investment policy statement. You are unlikely to write down, “buy stocks mentioned by Hermon in the cube next to mine” and are thus less likely to engage in such acts.
Cash and Inflation
I also try and keep a very small cash buffer. I always try and remain cognizant of the ravages inflation will do to cash over time. Looking at real returns is also helpful if you are bothered by volatility. Yes, those treasuries look a lot less volatile, but if you look back at the real returns, they have been decimated at times. I want my cash working as much as possible. One mental trick I use to reassure myself is to periodically review my access to loan proceeds via my retirement accounts. 401(k) and similar loans are often highly discouraged in typical financial media, but really if you divorce the decision to borrow from the determination as to the source, they aren’t that bad. I will probably do an article on this someday if there is any interest.
I’ve not had to take a 401(k) loan, but if I needed $50K next week for a new HVAC system I could get it there easily. The cost would be whatever the returns of the securities I sell to fund the loan are, but is probably better than decades of guaranteed real losses by hoarding tons of cash. I would also have other ways to get funds such as consumer loans and real estate secured financing. As I have discussed before, I am building up a hybrid bond allocation emergency fund of over time, but in the interim, I sleep fine at night with these potential sources of cash.
Coordinating With a Partner and Tracking
I also use a joint account to minimize the requirements to coordinate financial decisions with my partner. We use a joint account to pay joint/household expenses and the contributions to the account are based upon the size of our relative incomes. This way we don’t have to impose our spending views on one another. Ideally, we could get 100% on the same page, but I think this is a good compromise. I plan to try and demonstrate the merits of early financial independence by example, rather than “mansplaining” it (as much as I can).
Finally, I use goal setting and monthly tracking, combined with the automated saving to manage and maintain my budget indirectly; versus setting out categories for spending and then trying to fit the spending to the budget. I can certainly see the merits of the other method and I do periodically review my spending to see if there are any lurking problems, but I just prefer to work backward from the savings versus the other way around. I also enjoy logging the results and really have an abundance of interest in tracking. If I were less interested in financial topics I might prefer using YNAB or some budgeting software to stay on track.
Motivation – Tax
Finally, I use tax savings as a big motivator to really push the savings envelope. I will probably do a post about this in the future, but taxes are spending and you can really get pretty excited about saving when you look at how much better you can come out on an after-tax basis if you use the available tools/accounts. For example, let’s say your combined Federal, State and local marginal tax bracket is 45%. If you maxed out your $19,000 401(k) contribution in 2018, you just saved $8,550. Granted, you still have a deferred tax liability, but if you are a FIRE person you will probably get that back at 0 – 10% based on current tables. If you had a Self Employed 401(k) you might be able to sock away $50,000, saving $22,500 (or if you are a teacher!?!?). I have a few other little motivation games I play. I will discuss those another day.
In conclusion, I try to use the power of behavioral finance and some of the quirks of human cognition to enhance my personal financial situation. What do you do?