It’s been my experience that when most people think about money, it usually can be distilled to two central considerations: 1) how to make it and 2) how to allocate it.
For this reason, I think it is critically important in my work with clients to address three aspects of their mindset on money as described in my three-part series on the topic. In Part I (today), I review what I think is a critical shift in perspective as it relates to cash-flow, usually the life-blood of every family’s financial life. In Part II (in two weeks), I’ll lay out some helpful tools (I call “The Factors”) to help you make an informed decisions on just how much your spending is impacting your future goals. Finally, in Part III I’ll touch on the sometimes counter-intuitive mindset needed to successfully invest those assets over a long time horizon.
Part 1: How Does the Cash Flow?
As noted above, the two central considerations on cash flow (how to make it, how to allocate it) are like the largest two branches of a tree from which every other financial decision branches out. These offshoots are complex decisions and issues related to career choices (income), the “lifestyle” that is led (spending) along with longer-term investment allocations for retirement, etc. (saving)
It’s my belief all these questions are answered one of two ways, either implicitly or explicitly. The implicit way is just dealing with spending and savings as situations on a day-to-day basis as situations arise. Your paycheck is direct deposited into your checking account, you pay the mortgage and other bills, throw some money into the 529 and then maybe pay down those credit cards from that golf trip with the boys or that Florida get-away with the girls. You feel a little uneasy about retirement but take comfort in the fact that some money is “automatically” being placed into your 401(k) at work in whatever mutual funds you signed up for on your first day at the new job. Oh- and you still have some money sitting around at your old employer’s 401(k). Besides, you have plenty of time to catch up – right?
This is the default method and in my opinion is the equivalent of driving cross-country using only the sun as your guide- no maps or GPS. Are you generally headed in the right direction? Maybe, maybe not. But could you arrive much faster, with more certainty, less risk and in a more cost effective manner with a well-designed plan? Absolutely. And that’s where the “explicit” approach to finances comes in. That’s making investing and spending decisions in the context of a strategic and holistic plan while maintaining the ability to deal with inevitable uncertainties. Sitting down and figuring this out requires time, effort and mental discipline before you “get in the car” to make that trip. In a strategic financial plan, this means we must know our decision making process for each financial fork in the road. But before we do that, we must change the way we think about how the cash flows. And for that we must, as Steven Covey would say, “begin with the end in mind”.
With the implicit (or default) method, cash flows like this with Bucket #1 flowing into Bucket #2 and whatever is left over is Bucket #3 or what I call “The Juice”. (see below)
Bucket #1: What is coming in (income)
Bucket #2: What goes out (mortgage, insurance, groceries, restaurants, gasoline, credit card bills, etc.)
Bucket #3: What is left over after #2 is spent
But I believe this line of thinking is fundamentally flawed. Why? Because it is here in Bucket #3 (“The Juice”) where the funds and future growth for your ultimate dreams and goals lives. Instead of viewing this as “extra” money left over every month, this is really the sole funding source for retirement, children’s education, vacations and/or a legacy. I’m not breaking new ground hear- just re-stating what your Dad probably told us long ago (and we probably ignored at the time): “Pay yourself first”. This means the cash should flow like this:
Bucket #1: What is coming in (income)
Bucket #2: The “Juice” for your identified goals of retirement, college, long term meaningful goals
Bucket #3: Mortgage, insurance, groceries, restaurants, gasoline, credit card bills, etc.)
For those in the “default” or implicit way of spending / saving, this change in thinking about money can be a difficult adjustment. And in reality, you may already have purchased that large home or the boat or the slick Audi A8. But that doesn’t mean you can’t make changes going forward. Essentially, you’ll now be re-prioritizing and placing a higher importance of your goals (Bucket #2) vs. the near-term spending Bucket #3.
So this shift in perspective could best be illustrated in a scenario like this: The Jones (who everyone tries to keep up with) are 45 years old and make $250,000 per year. They want to retire at Age 65 and live on about $100,000 per year but have squirreled away only about $200,000 in retirement savings. So how much do they need to have when they retire to fund this lifestyle? Using some conservative assumptions, I come up with something like $2.1 million. And how much would they need to save for the next 20 years? $3,000 per month. How does that fit into the monthly budget???
The point is something usually has to give. And it really comes down to an honest assessment of what you value as a family. The difficult mental adjustment is delaying the near term gratification from the Coach purse / golf clubs with the long term goals of a comfortable retirement, etc. To make that adjustment, it is imperative to go through the exercise of actually figuring out the math behind these scenarios.
Seeing some of these numbers on a spreadsheet can be a slap in the face to some. But despite the cold reality of these calculations, I believe it is much more valuable to figure this out today versus 10 or 15 years from now when the only levers left to pull are working much longer while accepting a lower standard of living.