Should You Budge on Your Budget?

Yes. It is time for a new one.

This week, my undergrads are beginning their deep dive into 21st-century personal finance. I am having them read this retelling of a prior post. Let me know if this strikes a chord in you.

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During my undergraduate days, I interned for a financial services company where we read Clason’s “The Richest Man in Babylon,” a series of short stories about the importance of saving money.    That savings rate: 10%.   Clason wrote the book in 1926, and I recalled this book when thinking about the 10% rule of thumb offered by financial planners, writers, and advisors. Even today, it is as if it were some well-known and essential life skill like knowing how to do your laundry.  

It is not a good rule.

The truth is that today’s financial literacy education takes a similar tack. “Savings is a must for a happy life!” “Get in the habit of saving money.”

How do those words make you feel?

Ignore them. You are in control.

The Consumer Financial Protection Bureau produced focus group research about financial rules of thumb. They found participants learned from “mixtures of parental influence, trial and error, and what they have heard in the financial media.” When it came to decision-making, the research found “… consumers in our focus groups, while generally agreeing with many of the broad rules of thumb, expressed some doubt about the applicability of many of the rules to most consumers.” Yes, Yes, Yes!

It leads one to wonder why they persist when today’s technology permits you to do better. It is simple. And, simply wrong.

I guarantee you financial educators are partly to blame.

Skepticism Helps Understanding

I look around, and there are plenty of circumstances during a lifetime when borrowing money is more important.   The loan to help buy a car needed to get to work; the mortgage to help a family buy their home in a five-star school district.    A great-grandmother near the end of her lifetime shouldn’t be saving.   The minimum wage worker trying to pay the rent and buy food should not necessarily be saving.     It is hard to judge financially foolhardy the millennial coder who loves her work, never plans on retiring, and has no interest in savings because she wants to enjoy today.

In personal finance economics, household preferences, attributes, goals, and trade-offs are essential to any financial plan.

Your financial resources, objectives, and preferences are key.

Proper savings are not necessarily a prescriptive habit. It results from a well-crafted economics-based approach to helping a household achieve its highest living standard. It really is that simple.  

It is what our book is about.

When you read or hear pithy savings phrases, think carefully about who is the purveyor of the information. In general, the same savings advice is indeed short-sighted.   

To give you the scale of “the miss” with conventional advice, consider Sarah, a single, millennial coder who lives in California and earns $120,000 today. Sarah expects to work her entire life until she is 85. She would have an optimized standard of living in today’s dollars of $37,950. If she began this year saving 10% of her pre-tax income in a brokerage account with a return that matches the inflation rate, her standard of living would become $23,054 (a living standard drop of 40%), and at death, she would leave more than $600,000 on the table. Where should that extra money go? What if Sarah is not charitably inclined? These are important questions and factors that go into life-cycle planning.That is quite a few beanies, an upgraded car, and trips up and down Highway 1.

A 40% reduction is Sarah’s result. It may not be your result. That is the point. For a rule of thumb to be good, it must be generalizable.

Prescriptive, economics-based personal financial planning will advise savings for specific individuals and households. Just not all of them. People save because they want to retire, make a large purchase, and put money on reserve. Some parents want to budget for their children’s education or leave their heirs a nest egg.   Valid reasons indeed, and whatever the reason for a specific household, there will be an effect on the household’s living standard today and in the future.   Because household makeup, existing assets, and life trajectories differ, living standard outcomes and savings amounts will differ. Make sense?