Myths On Money

On a special request, this post will take a quick look at how you can approach the task of deciding how much “fun money” to allow in your budget.

Not Science, But Close Enough

Like lots of other aspects of personal finance, the decision of how much fun money is too much depends on a huge number of factors, all of which will vary from person to person and family to family. And, while it is not an exact science, there are a couple of different ways the question can be approached and solved.

How Much?

Let’s jump straight to the heart of the question. Exactly how much, in total, should be budgeted for fun? In general, in should be a small percentage (less than 10%) of your monthly income, but there are always exceptions. It is generally far more effective to take a look at three factors when deciding the exact dollar amount: what you like to do, how much it costs to do it, and how often you like to do it.

1. Write Down Things You Like To Do. Start out by writing down things your family likes to do for fun that cost money. This can include everything from baseball games to fast food outings. Just list what they are for now.
2. Note How Much You Usually Spend. Next, go through your list and estimate how much you spend on each activity. $20 for dinner? $6 for ice cream?

3. Figure How Often To Do Each Activity. At this point, it’s time to decide how often you like to do the activities you have listed. Count how many times per month you typically would do the activity in question. It is okay to use partial months, here. If you usually go only once every 3 months or so, then write down .33 times per month. If you like to go once a week, then write down 3 or 4 times per month.

4. Multiply! Now, take the dollar amount for each activity and multiply it by the number of times per month, then add all of those numbers up. This should give you a number of dollars per month to budget for. Remember that this number is not set in stone, and that you can adjust it as you need to. The screenshot below will give you an idea of how the whole system works.

At this point, it would be good to remember that just because you have budgeted money for fun does not mean that you need to spend it. In the example chart above, baseball games are estimated to be a once every-other-month activity (times/month = .5). If you maintain your budget, then every other month you would have a little extra so that the baseball game could be afforded. This method of estimation does not mean that you must spend “according to schedule”. In the example above, it is perfectly acceptable to go out fine dining three times a month and forego all other activities. The point of this method is to get to the bottom line, not to schedule your future activities.

Cutting Corners

Now, what to do if you find your fun budget is too large to enable you to reach your savings goals? If you find yourself in this dilemna, then you need to take a step back and examine your priorities. What is more important to you, the savings or the fun? The answer to that question will determine what you should do. If you would rather have fun than save, then you should reduce the amount you save (remember,a budget that is too strict will never be followed, and thus becomes useless!). If you would prefer to save, then you will have to find a way to reduce how much you spend on fun activities.

There are a few ways to change how much you spend each month for fun. The first is the most obvious, but also likely the hardest. Reduce how often you go out for fun. Go out to eat less, wait for movies to come to the dollar-theaters, etc. This would undoubtedly work, but it can be hard. A slightly easier option is to try to reduce the cost of the activity. Buy cheaper tickets, order cheaper menu items, etc. A less onerous, but also less obvious, approach is to invest in the things you love. Let me give an example. Let’s say you love to go to the batting cages. Instead of paying $5 to go to the batting cages, you could instead pay $15 for a bag of baseballs and go to the park. The baseballs may be more expensive at first, but over the long run, they will prove a very profitable investment. Using the baseballs once a month for a year would save enough money to make the basballs an investment returning 386%!!! Note that in order for such an investment to be effective in saving you money, you must USE your investment. If you buy a bag of baseballs and sit them on a shelf, then it is a pure loss, and you would be better off going to the batting cages.

Another way that you can help motivate yourself to spend less money on fun activities is to remember what you are saving for. Remember, savings are not accumulated for no reason. When you are deciding if you would prefer to save or spend, consider what you are really getting when you save. Today’s savings are tomorrow’s purchases. So when you save today, you enable yourself to buy tomorrow. So what do you want to buy tomorrow? A nice retirement? A trip to Disneyland? A new home? The ability to spend your days however you wish, with no need to work? Remember that your savings are the only way that you will acheive your goals and have the lifestyle you have always wanted.

The Word on the Street:

There is an almost universal and constant complaint that political leaders (particularly the U.S. President) have destroyed the U.S. economy, and if there were a change in leadership things could immediately improve.

The Truth:

A free-market system (like the one in U.S.), almost has a mind of its own, and cannot be directly controlled or manipulated. Such control is only possible in a socialistic economy. While there are some aspects of a free market economy that can be influenced by politicians, the market as a whole is controlled by each individual. It is controlled by you and by me.

(This post attempts to compress the critical points from many courses of economics and finance. All references refer to the economic system in place in the United States.)

Free Market?

A market is a place where goods and services may be exchanged. When economists speak of “free” markets, they mean that the prices and terms of exchange in the market are controlled exclusively by the forces of supply and demand. The more of a good that is demanded by the buyers, the higher the price it can be sold for, and vice-versa. Likewise, the more of a good is or can be supplied by producers, the lower the price of the good, and vice-versa. This is fairly intuitive; if your friend has 100 cookies and you want one, he may well give you one for free, but if he only has one cookie and you want, you may have to offer him a lot for it.

So, in a free market system, the prices of goods are dependant upon how much of a good is demanded, and how much can be produced. When you buy a gallon of milk, you create demand for milk and help drive the price up. When farmers have a good crop of corn, the supply increases and corn will be cheaper. Now, the influence of an individual is small relative to the size of the market (in the U.S., it’s millions and millions of people), but our individual buying habits collectively come together to determine how the economy operates.

So What Can They Do?

There are a few aspects of the economy that can be influenced by political policy. However, bear in mind that the actions listed here do not effect the economy in the same way that turning the wheel effects a car. A closer comparison would be to say that it is like steering a horse by dangling a carrot in front of it. Just because a certain action should have a certain effect does not mean that it always will; there may be stronger influences to affect the course of the economy. These tools simply apply pressure to the economy to try to stimulate it to move in certain directions.

1. Interest rates. This is probably the most important and effective tool the government has for influencing the economy. The Federal Reserve board meets regularly to decide what the base interest rate for the country should be. The lower they set the rate, the cheaper money becomes. Interest rates on loans drop and money becomes easier to get. This causes spending to increase, which tends to push stock prices up and gives the economy a boost. This boost does not come without a price, though. With increased spending, inflation begins to become more of a problem. In the current economic slump, interest rates have been lowered to all time record lows in order to encourage spending and the issuance of mortgages.
   
   Raising interest rates has the opposite effect. It makes money more expensive, puts pressure on people to reduce spending, which cuts into the earnings of companies and can depress stock prices. On the bright side, it makes it so that consumer deposit accounts (i.e. savings accounts) yield higher returns, and tends to tamp down on inflationary pressures. The Fed may soon be forced to raise rates in an attempt to curb rising inflation, but even should they do so, it is unlikely that the current inflation in the economy will subside completely. Raising the rates will likely slow the inflation rate, but not stop it in its tracks. This is because there are other forces at work (like the rising price of gas [caused by rising world-wide demand for oil and by speculative pressures]) that are causing inflation.
2. Trade Policy. This is a area that is also very important. Trade is a wonderful thing because it generates wealth for everyone involved. By trading goods and services, both parties can come out better off for the exchange. By maintaining free trade laws, the U.S. can import goods at a lower price than it could manufacture them for, and can export goods which it can produce cheaply. Thus everyone winds up buying at the lowest prices possible. By enforcing trade barriers, the price of foreign goods goes up in the U.S., and the quantity available in the U.S. declines. Think about how often you buy foreign products like Sony TVs, Honda cars, Chinese made toys, etc and you begin to understand the ramifications of impeding trade. The effect of barring trade can be huge.
3. Industry Support. This one has come into the limelight with the mortgage crisis. There are times when the government can step in to help an ailing industry. Lately, it has been mortgage lenders who have been the recipients of government aid. Government aid can come in many forms. The ethanol industry has been benefiting from governmental subsidies; basically, the government has been giving money to ethanol producers because they cannot yet produce ethanol profitably. Once (if) the ethanol industry becomes established, the subsidies will cease and an entire industry will have been born which could otherwise have never gotten off the ground.
4. Regulation. One of the government’s most visible roles in the economy is the establishment of regulatinos that companies must adhere to. Such regulations are usually intended to help protect the public interest. Because a company (and insurance company, for example) has more intimate knowledge of the products and services it provides, there is an opportunity for the company to exploit an ignorant consumer. Government regulation helps prevent this. Government regulation can also be used to protect the environment or other public concerns. Such regulation may hinder a company from realizing it’s maximum profitability potential, but protects those who otherwise might not be able to protect themselves.
5. Taxes. Of course changing how much people and companies pay in taxes also effects the economy. By reducing taxes, companies become more profitable and consumers find themselves able to purchase more. This helps promote growth in the economy, but can also pose a hindrance to government spending. A healthy balance must be maintained so that the economy does not overpay in taxes, and the government can still have enough funds to accomplish it’s purposes.

Who’s To Blame?

Everybody wants to blame someone else for the economic slump in the US, but really, we have only ourselves to blame. Companies that issued sub-prime loans should not have issued them, true, but those who took the loans should not have taken them because they could not afford them. Why are banks going under? Is it because borrowers are not paying their loans? Yes, in part. Borrowers should not have taken debt which they could not afford. But there is a second part to the story of bank failure, and the recent collapse of Bear Stearns (one of the premier Wall Street brokerage firms) illustrates the problem. Bear Stearns was in great financial condition, and still is. So why, then, was it sold to JP Morgan Chase? The answer: lack of cash. Bear Sterns has tons of assets, but it ran out of spendable cash to pay its own debts with. This is the same problem many of the banks are facing. Why are banks running out of cash? Part, as stated above, comes from delinquent loans. But the other part comes from a lack of personal savings. Banks get their money from their members. If members save $10 million in a bank, then the bank has $10 million to work with. With savings rates pitifully low over the past several years, banks have been running out of money, and without money in their coffers, the banks cannot meet all of their obligations and are forced out of business.

So What is to be Done?

The change in the economy must start inside every household in the country. All of us must take care of our personal finances. We must be careful spenders AND careful savers. We must save money and invest in stocks and bonds so that the banks will not go under and so the stock prices can rise. We must also spend money. It is critical that companies received revenue from sales, or they will go under.

How can we both spend and save? It is not easy, but a critical point in doing so is to be careful in what we purchase. Only purchase goods that you need, only purchase goods that are fairly priced, and, most importantly, only purchase goods that you can afford. It is past overspending that is killing the US economy, one family at a time. Spending in itself is not bad, but spending more than you have is catastrophic, and we are now realizing the full consequences of our habits.

Personal finance is really not all that difficult. In fact, most people could probably maintain their finances in good health without any assistance whatsoever if they had only been taught the subtle nuances of money and the implications of various cash flows. In this MythTip, we’ll take a look at one way in which you can gear your mind to think like a finance professor.

Apples to Apples

In another post, I mentioned the fact that sometimes financial calculations can give skewed information because of the incompatibility of the cash flows being used. This is the first, and perhaps most important rule of financial understanding: you must compare apples to apples.

For example, let us say that you have the opportunity to save $10 per month. Many people might say that $10 is not very much money. But not the financier. The financier may profitably take a different perspective. What if that $10 was considered as interest placed into a high-yield savings account? How would the effective interest rate be changed if the account were to receive an additional $10 a month? Let’s say the account currently has $10,000 and yields 3.5%. This means that the account currently earns $29/month in interest. If the $10 were added to the account, that would be the same as the account earning $39/month. A $39/month gain on $10,000 turns out to be 4.68%. Who among us would say reject the opportunity to increase the return on our savings by 34%? That’s a big difference, but it was made by a small amount of money. Just imagine if $50, or $100 were saved instead of $10. What if you can reduce your grocery bill by $25 each month by using buying less expensive brands? How about slowing the car down to save $30/month in gas? Remember, to the financially minded, money saved is equivalent to money earned. Spending $10 is the same as earning $10 less, and saving $10 is the same as earning $10 more.

So maybe saving $10 a month can be a big deal. It is important that all cash flows be considered in comparable terms. In the example above, we changed a dollar-savings to an effective interest rate increase in order to visualize the impact those $10 could have on a savings account. Now, it is true that the more money you have the more money you need in order to have the same kind of impact as shown above. The true point, however, is that a bit of money that may seem small in comparison to one thing (ie $10 compared to your monthly income), may be large when compared to another thing (like the interest earned on the savings account). Such small steps can give big results, given time. So start now to think like a financier. Even if you do not know how to do the calculations required to make these comparisons, you can still use your judgment to estimate. And when in doubt, find someone who can help.