A Financial Planner’s thoughts on Personal Finance
Link Asset Management has a podcast that covers various concepts related to financial planning and reviews books on the subject. While I enjoy audio content because I drive for work quite a bit, many enjoy written content. With that in mind, I will create blog versions of past and future episodes for those who prefer to read!
There is an ocean of content regarding finance (including this!). Still, it does not apply to everyone and often shortcuts the truth in harmful ways.
Many oversimplified concepts and straight sales pitches claim to offer advice. Knowing a few basics will give you context for what people are saying and enable you to sort out the wheat from the chaff.
To start with, while the terms for a business or corporation's finances and personal finances are different, they mostly equate to the same thing with varying levels of complexity.
Cash Flow Statement = Money in and Out
Naturally, expenses must occur in life and business. Those expenses drive the need for income, but the "Net" is what you make minus what you spend. A cash flow statement is a budget, and it keeps track of how much is going out vs. what is coming in.
Something notable is the difference between revenue and profit, which is often incorrectly conflated in social media.
Revenue is the amount of money coming in, period, regardless of the cost to produce that cash flow.
Profit is the amount of money left after all expenses generated to produce the revenue are accounted for. THIS is what is important regarding a business's success.
Statement of Financial Position = Net Worth = How much you own minus what you owe
Money is not the only thing we possess of value. We usually will have cars, houses, etc., contributing to our total value. A person's net worth is the money someone would have if they sold every asset they owned and turned it into cash.
There are many more statements in between that allow financial professionals to make decisions and forecasts, but we won't get into that here.
What can we learn from the fact that every single business tracks its financial situation in a primarily uniform manner? That it needs to be tracked!
Double Accounting and Parkinson's Law
The accepted form of accounting is "double accounting," which alludes to the fact that every entry is doubled in some way.
For instance, a business's profit will be entered as a credit on one side of the balance sheet and shown as "equity to owners" or something similar, as a debit, on the other side. The system's counterintuitive aspect is also its most useful part; everything must end up at 0. Why is this useful?
In the above example, the profit the company is making is negated by the same amount going to the owners. This process checks to make sure everything is accounted for!
For personal applications, this equates to the saying, "Mind the cents, and the dollars mind themselves." Tracking in this way shows where every single dollar is going. It is very common, especially for those with higher incomes, to lose track of all but the most necessary expenditures, and as a result, even those with high incomes fail to build wealth.
I often refer to Parkinson's law in this scenario, the original version of which is "work expands to fill the available time." You may remember in school that a project would fill the time assigned to it regardless of how big it actually was.
This same concept can be applied to one's budget, that your spending expands to fill the available resources ( this is also known as lifestyle inflation, which is for another time)
Allocating your resources with the double accounting philosophy in mind allows you to know where your hard-earned wealth is going and hold onto it as necessary to grow it.
With that said, the question is, what should we focus on when tracking our finances?
One of my favorite books, The Richest Man in Babylon, is famous in the financial sphere. What I love about it is how it communicates essential concepts of finance in allegorical form. The story is of, predictably, the wealthiest man in Babylon and how he informs the people through stories about how to build wealth.
Here are some of the critical lessons.
How much are you making, and can you make more?
(Set thy purse to fattening)
If you make just enough to cover expenses, more is needed to grow your wealth. The first lesson of the book is the hardest and the one people least like to hear. You must make enough to earn past your expenditures so that you have something to grow.
How much are you spending?
(paying everyone else first)
It is common for us to spend our money as soon as there is extra. The book refers to this as "paying everyone else first" because you are paying the clothing maker, the jewelry maker, etc., rather than giving that money to yourself. After you have enough money to live on, the next part is to hold onto that money rather than send it back out the door.
This post is not a full book review, but the book also brings up the following thoughts:
How much are you REQUIRED to spend?
Debts
Living Expenses
Emergency Savings Amount
How much can you save without hating every second?
I often think of this concept as a diet. If your diet is so strict that every moment is miserable, you will likely not stick to it.
Can you reduce the amount you are required to spend each month?
We often tell ourselves that certain things are necessary when, objectively, they are not. The most common culprit I see with clients (and frankly myself) is eating out because food is necessary. One can meal prep for a fraction of the cost, though it's often not as fun!
There are many ways to apply these thoughts, but they are a good starting point. Any particular system may not work for an individual. Still, these philosophies are the common denominators for improving one's financial position.
While I will likely review the book in its entirety in the future, I suggest reading The Richest Man in Babylon. The concepts are well communicated and applicable to almost everyone, especially those starting out.
Remember to subscribe to the newsletter and podcast, and I'll see you next time!