Budgeting Basics: How to Create a Budget and Stick to It thumbnail

Budgeting Basics: How to Create a Budget and Stick to It

Published May 15, 24
17 min read

Financial literacy is a set of skills and knowledge that are necessary to make good decisions when it comes to one's money. This is like learning the rules of an intricate game. As athletes must master the fundamentals in their sport, people can benefit from learning essential financial concepts. This will help them manage their finances and build a solid financial future.

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In the complex financial world of today, people are increasingly responsible for managing their own finances. Financial decisions, such as managing student debts or planning for your retirement, can have lasting effects. A study by FINRA’s Investor Education foundation found a relationship between high financial education and positive financial behaviours such as planning for retirement and having an emergency fund.

It's important to remember that financial literacy does not guarantee financial success. Some critics argue that focusing on financial education for individuals ignores systemic factors that contribute to financial inequity. Some researchers suggest that financial education has limited effectiveness in changing behavior, pointing to factors such as behavioral biases and the complexity of financial products as significant challenges.

Another perspective is that financial literacy education should be complemented by behavioral economics insights. This approach acknowledges that people do not always make rational decisions about money, even if they are well-informed. These strategies based on behavioral economy, such as automatic enrollments in savings plans have been shown to be effective in improving financial outcomes.

The key takeaway is that financial literacy, while important for managing personal finances and navigating the economy in general, is just a small part of it. Financial outcomes are influenced by a variety of factors including systemic influences, individual circumstances and behavioral tendencies.

Fundamentals of Finance

Basic Financial Concepts

Financial literacy begins with the fundamentals. These include understanding:

  1. Income: The money received from work, investments or other sources.

  2. Expenses: Money spent on goods and services.

  3. Assets: Items that you own with value.

  4. Liabilities: Debts or financial commitments

  5. Net Worth: the difference between your assets (assets) and liabilities.

  6. Cash Flow: The total amount of money being transferred into and out of a business, especially as affecting liquidity.

  7. Compound Interest (Compound Interest): Interest calculated based on the original principal plus the interest accumulated over previous periods.

Let's dig deeper into these concepts.

Earnings

The sources of income can be varied:

  • Earned income - Wages, salaries and bonuses

  • Investment income: Dividends, interest, capital gains

  • Passive income: Rental income, royalties, online businesses

Understanding the different income streams is important for tax and budget planning. In most tax systems, earned-income is taxed higher than long term capital gains.

Assets vs. Liabilities

Assets are items that you own and have value, or produce income. Examples include:

  • Real estate

  • Stocks & bonds

  • Savings accounts

  • Businesses

Financial obligations are called liabilities. Included in this category are:

  • Mortgages

  • Car loans

  • Charge card debt

  • Student loans

A key element in assessing financial stability is the relationship between assets, liabilities and income. Some financial theories recommend acquiring assets which generate income or gain in value and minimizing liabilities. Not all debts are bad. For instance, a home mortgage could be seen as an investment that can grow over time.

Compound Interest

Compound Interest is the concept that you can earn interest on your own interest and exponentially grow over time. This concept is both beneficial and harmful to individuals. It can increase investments, but it can also lead to debts increasing rapidly if the concept is not managed correctly.

Imagine, for example a $1,000 investment at a 7.5% annual return.

  • After 10 years, it would grow to $1,967

  • After 20 Years, the value would be $3.870

  • After 30 years, it would grow to $7,612

This demonstrates the potential long-term impact of compound interest. But it is important to keep in mind that these examples are hypothetical and actual investment returns may vary and even include periods when losses occur.

Knowing these basic concepts can help individuals create a better picture of their financial status, just as knowing the score helps you plan your next move.

Financial Planning and Goal Setting

Financial planning is about setting financial objectives and creating strategies that will help you achieve them. The process is comparable to an athlete’s training regime, which outlines all the steps required to reach peak performance.

Elements of financial planning include:

  1. Setting SMART (Specific, Measurable, Achievable, Relevant, Time-bound) financial goals

  2. Creating a budget that is comprehensive

  3. Develop strategies for saving and investing

  4. Regularly reviewing and adjusting the plan

Setting SMART Financial Goals

In finance and other fields, SMART acronym is used to guide goal-setting.

  • Specific goals make it easier to achieve. Saving money is vague whereas "Save $10,000" would be specific.

  • Measurable - You should be able track your progress. In this example, you can calculate how much you have saved to reach your $10,000 savings goal.

  • Achievable goals: The goals you set should be realistic and realistic in relation to your situation.

  • Relevant: Goals should align with your broader life objectives and values.

  • Setting a specific deadline can be a great way to maintain motivation and focus. For example, "Save $10,000 within 2 years."

Budgeting in a Comprehensive Way

A budget is an organized financial plan for tracking income and expenditures. This is an overview of how to budget.

  1. Track all your income sources

  2. List your expenses, dividing them into two categories: fixed (e.g. rent), and variable (e.g. entertainment).

  3. Compare the income to expenses

  4. Analyze the results, and make adjustments

The 50/30/20 rule has become a popular budgeting guideline.

  • 50 % of income to cover basic needs (housing, food, utilities)

  • Enjoy 30% off on entertainment and dining out

  • Save 20% and pay off your debt

It is important to understand that the individual circumstances of each person will vary. Such rules may not be feasible for some people, particularly those on low incomes with high living expenses.

Savings and Investment Concepts

Savings and investment are essential components of many financial strategies. Here are some similar concepts:

  1. Emergency Fund: A savings buffer for unexpected expenses or income disruptions.

  2. Retirement Savings - Long-term saving for the post-work years, which often involves specific account types and tax implications.

  3. Short-term Savings : For savings goals that are within 1-5 years. Usually kept in accounts with easy access.

  4. Long-term investments: For goals that are more than five years away. Often involves a portfolio of diversified investments.

It is important to note that there are different opinions about how much money you should save for emergencies and retirement, as well as what an appropriate investment strategy looks like. These decisions are based on the individual's circumstances, their risk tolerance and their financial goals.

Financial planning can be thought of as mapping out a route for a long journey. This involves knowing the starting point, which is your current financial situation, the destination (financial objectives), and the possible routes to reach that destination (financial strategy).

Diversification of Risk and Management of Risk

Understanding Financial Risks

Financial risk management is the process of identifying and mitigating potential threats to a person's financial well-being. This is similar in concept to how athletes prepare to avoid injuries and to ensure peak performance.

Financial risk management includes:

  1. Identification of potential risks

  2. Assessing risk tolerance

  3. Implementing risk mitigation strategies

  4. Diversifying Investments

Identifying Potential Hazards

Financial risks can come from various sources:

  • Market risk is the possibility of losing your money because of factors that impact the overall performance on the financial markets.

  • Credit risk: The risk of loss resulting from a borrower's failure to repay a loan or meet contractual obligations.

  • Inflation risk: The risk that the purchasing power of money will decrease over time due to inflation.

  • Liquidity risks: the risk of not having the ability to sell an investment fast at a fair market price.

  • Personal risk: A person's own specific risks, for example, a job loss or a health issue.

Assessing Risk Tolerance

Risk tolerance is the ability of a person to tolerate fluctuations in their investment values. Risk tolerance is affected by factors including:

  • Age: Younger persons have a larger time frame to recover.

  • Financial goals: A conservative approach is usually required for short-term goals.

  • Income stability: A stable income might allow for more risk-taking in investments.

  • Personal comfort: Some individuals are more comfortable with risk than others.

Risk Mitigation Strategies

Common risk-mitigation strategies include

  1. Insurance: Protection against major financial losses. This includes health insurance, life insurance, property insurance, and disability insurance.

  2. Emergency Fund - Provides financial protection for unplanned expenses, or loss of income.

  3. Maintaining debt levels within manageable limits can reduce financial vulnerability.

  4. Continuous Learning: Staying updated on financial issues will allow you to make better-informed decisions.

Diversification: A Key Risk Management Strategy

Diversification is a risk management strategy often described as "not putting all your eggs in one basket." Spreading investments across different asset classes, industries and geographical regions can reduce the impact of a poor investment.

Consider diversification similar to a team's defensive strategies. To create a strong defensive strategy, a team does not rely solely on one defender. They use several players at different positions. A diversified portfolio of investments uses different types of investment to protect against potential financial losses.

Diversification Types

  1. Diversifying your investments by asset class: This involves investing in stocks, bonds or real estate and a variety of other asset classes.

  2. Sector Diversification (Investing): Diversifying your investments across the different sectors of an economy.

  3. Geographic Diversification is investing in different countries and regions.

  4. Time Diversification is investing regularly over a period of time as opposed to all at once.

Although diversification is an accepted financial principle, it doesn't protect you from loss. All investments carry some level of risk, and it's possible for multiple asset classes to decline simultaneously, as seen during major economic crises.

Some critics say that it is hard to achieve true diversification due to the interconnectedness of global economies, especially for individuals. Some critics argue that correlations between assets can increase during times of stress in the market, which reduces diversification's benefits.

Diversification remains an important principle in portfolio management, despite the criticism.

Investment Strategies and Asset Allocation

Investment strategies help to make decisions on how to allocate assets among different financial instruments. These strategies could be compared to a training regimen for athletes, which are carefully planned and tailored in order to maximize their performance.

The key elements of investment strategies include

  1. Asset allocation: Divide investments into different asset categories

  2. Spreading your investments across asset categories

  3. Rebalancing and regular monitoring: Adjusting your portfolio over time

Asset Allocation

Asset allocation is a process that involves allocating investments to different asset categories. The three main asset classes include:

  1. Stocks are ownership shares in a business. Stocks are generally considered to have higher returns, but also higher risks.

  2. Bonds Fixed Income: Represents loans to governments and corporations. The general consensus is that bonds offer lower returns with a lower level of risk.

  3. Cash and Cash Equivalents includes savings accounts and money market funds as well as short-term government securities. These investments have the lowest rates of return but offer the highest level of security.

Asset allocation decisions can be influenced by:

  • Risk tolerance

  • Investment timeline

  • Financial goals

You should be aware that asset allocation does not have a universal solution. There are some general rules (such as subtracting 100 or 110 from your age to determine what percentage of your portfolio could be stocks) but these are only generalizations that may not work for everyone.

Portfolio Diversification

Diversification can be done within each asset class.

  • For stocks, this could include investing in companies with different sizes (small cap, mid-cap and large-cap), industries, and geographical areas.

  • Bonds: The issuers can be varied (governments, corporations), as well as the credit rating and maturity.

  • Alternative investments: Some investors consider adding real estate, commodities, or other alternative investments for additional diversification.

Investment Vehicles

There are several ways to invest these asset classes.

  1. Individual Stocks and Bonds: Offer direct ownership but require more research and management.

  2. Mutual Funds are professionally managed portfolios that include stocks, bonds or other securities.

  3. Exchange-Traded Funds: ETFs are similar to mutual funds, but they can be traded just like stocks.

  4. Index Funds (mutual funds or ETFs): These are ETFs and mutual funds designed to track the performance of a particular index.

  5. Real Estate Investment Trusts, or REITs, allow investors to invest in property without owning it directly.

Active vs. Passive Investing

There is a debate going on in the investing world about whether to invest actively or passively:

  • Active investing: Investing that involves trying to beat the market by selecting individual stocks or timing market movements. Typically, it requires more knowledge, time and fees.

  • Passive Investing: Involves buying and holding a diversified portfolio, often through index funds. The idea is that it is difficult to consistently beat the market.

This debate is ongoing, with proponents on both sides. Advocates of active investing argue that skilled managers can outperform the market, while proponents of passive investing point to studies showing that, over the long term, the majority of actively managed funds underperform their benchmark indices.

Regular Rebalancing and Monitoring

Over time, certain investments may perform better. This can cause a portfolio's allocation to drift away from the target. Rebalancing is the periodic adjustment of the portfolio in order to maintain desired asset allocation.

Rebalancing can be done by selling stocks and purchasing bonds.

It is important to know that different schools of thought exist on the frequency with which to rebalance. These range from rebalancing on a fixed basis (e.g. annual) to rebalancing only when allocations go beyond a specific threshold.

Consider asset allocation similar to a healthy diet for athletes. In the same way athletes need a balanced diet of proteins carbohydrates and fats, an asset allocation portfolio usually includes a blend of different assets.

Keep in mind that all investments carry risk, which includes the possibility of losing principal. Past performance does not guarantee future results.

Long-term Retirement Planning

Long-term planning includes strategies that ensure financial stability throughout your life. This includes estate planning as well as retirement planning. These are comparable to an athletes' long-term strategic career plan, which aims to maintain financial stability even after their sport career ends.

Long-term planning includes:

  1. Understanding retirement options: Understanding the different types of accounts, setting goals and estimating future costs.

  2. Estate planning: preparing for the transference of assets upon death, including wills and trusts as well as tax considerations

  3. Health planning: Assessing future healthcare requirements and long-term care costs

Retirement Planning

Retirement planning involves understanding how to save money for retirement. Here are a few key points:

  1. Estimating retirement needs: According to certain financial theories, retirees will need between 70-80% their pre-retirement earnings in order to maintain a standard of life during retirement. The generalization is not accurate and needs vary widely.

  2. Retirement Accounts

    • 401(k), also known as employer-sponsored retirement plans. They often include matching contributions by the employer.

    • Individual Retirement accounts (IRAs) can either be Traditional (potentially deductible contributions; taxed withdrawals) or Roth: (after-tax contribution, potentially tax free withdrawals).

    • SEP IRAs and Solo 401(k)s: Retirement account options for self-employed individuals.

  3. Social Security is a government program that provides retirement benefits. It's crucial to understand the way it works, and the variables that can affect benefits.

  4. The 4% rule: A guideline that suggests retirees can withdraw 4% of their retirement portfolio the first year after retiring, and then adjust this amount each year for inflation, with a good chance of not losing their money. [...previous content remains the same...]

  5. The 4% Rule is a guideline which suggests that retirees should withdraw 4% from their portfolio during the first year after retirement. They can then adjust this amount each year for inflation, and there's a good chance they won't run out of money. The 4% rule has caused some debate, with financial experts claiming it is either too conservative or excessively aggressive depending on the individual's circumstances and the market.

Important to remember that retirement is a topic with many variables. Retirement outcomes can be affected by factors such as inflation rates, market performance and healthcare costs.

Estate Planning

Planning for the transference of assets following death is part of estate planning. Key components include:

  1. Will: Document that specifies how a person wants to distribute their assets upon death.

  2. Trusts: Legal entity that can hold property. Trusts come in many different types, with different benefits and purposes.

  3. Power of attorney: Appoints someone to make decisions for an individual in the event that they are unable to.

  4. Healthcare Directive: This document specifies an individual's wishes regarding medical care in the event of their incapacitating condition.

Estate planning can be complicated, as it involves tax laws, personal wishes, and family dynamics. The laws governing estates vary widely by country, and even state.

Healthcare Planning

As healthcare costs continue to rise in many countries, planning for future healthcare needs is becoming an increasingly important part of long-term financial planning:

  1. Health Savings Accounts - In some countries these accounts offer tax incentives for healthcare expenses. Eligibility and rules can vary.

  2. Long-term insurance policies: They are intended to cover the cost of care provided in nursing homes or at home. Cost and availability can vary greatly.

  3. Medicare is a government-sponsored health insurance program that in the United States is primarily for people aged 65 and older. Understanding Medicare's coverage and limitations can be an important part of retirement plans for many Americans.

There are many differences in healthcare systems around the world. Therefore, planning healthcare can be different depending on one's location.

This page was last edited on 29 September 2017, at 19:09.

Financial literacy covers a broad range of concepts - from basic budgeting, to complex investing strategies. As we've explored in this article, key areas of financial literacy include:

  1. Understanding basic financial concepts

  2. Developing financial planning skills and goal setting

  3. Diversification of financial strategies is one way to reduce risk.

  4. Understanding different investment strategies, and the concept asset allocation

  5. Planning for long term financial needs including estate and retirement planning

It's important to realize that, while these concepts serve as a basis for financial literacy it is also true that the world of financial markets is always changing. Changes in financial regulations, new financial products and the global economy all have an impact on personal financial management.

Financial literacy is not enough to guarantee success. As discussed earlier, systemic factors, individual circumstances, and behavioral tendencies all play significant roles in financial outcomes. Critics of financial education say that it does not always address systemic inequalities, and may put too much pressure on individuals to achieve their financial goals.

Another perspective emphasizes the importance of combining financial education with insights from behavioral economics. This approach recognizes the fact people do not always take rational financial decision, even with all of the knowledge they need. Financial outcomes may be improved by strategies that consider human behavior.

The fact that personal finance rarely follows a "one-size-fits all" approach is also important. What works for one person may not be appropriate for another due to differences in income, goals, risk tolerance, and life circumstances.

Learning is essential to keep up with the ever-changing world of personal finance. This may include:

  • Staying informed about economic news and trends

  • Financial plans should be reviewed and updated regularly

  • Find reputable financial sources

  • Consider professional advice for complex financial circumstances

Although financial literacy can be a useful tool in managing your personal finances, it is not the only piece. To navigate the financial world, it's important to have skills such as critical thinking, adaptability and a willingness for constant learning and adjustment.

The goal of financial literacy, however, is not to simply accumulate wealth but to apply financial knowledge and skills in order to achieve personal goals and financial well-being. For different people, financial literacy could mean a variety of things - from achieving a sense of security, to funding major life goals, to being in a position to give back.

By gaining a solid understanding of financial literacy, you can navigate through the difficult financial decisions you will encounter throughout your life. It's important to take into account your own circumstances and seek professional advice when necessary, especially with major financial decisions.


The information provided in this article is for general informational and educational purposes only. It is not intended as financial advice, nor should it be construed or relied upon as such. The author and publishers of this content are not licensed financial advisors and do not provide personalized financial advice or recommendations. The concepts discussed may not be suitable for everyone, and the information provided does not take into account individual circumstances, financial situations, or needs. Before making any financial decisions, readers should conduct their own research and consult with a qualified financial advisor. The author and publishers shall not be liable for any errors, inaccuracies, omissions, or any actions taken in reliance on this information.