Cover image credit: “Budgeting” by 401kcalculator.org is licensed under CC BY 2.0.

Personal financial planning is not very complicated when you understand its basic principles.

Budgeting lies at the heart of financial planning.

The three main quantities

A budget essentially deals with three main quantities:

1. income
2. expenses
3. savings/investments

Income, which we also refer to as “rem”, comes in two varieties: active or passive. Active income usually takes the form of a salary you draw from your job or the money you make in your gig. Passive income usually consists of items like the interest you earn on the money sitting in your bank accounts.

The next important quantity in the budget is your expenditure. This consists of living expenses such as food, shelter, etc. The conventional budgeting philosophy categorizes expenses into two buckets: needs and wants. However, it is much more accurate to think of them as lying on a reqs spectrum.

Income and expenses will rarely match up over any given period of time. The difference between the two are your savings or investments¹, and they form the last component of your budget. If your income is lower than your expenses, you’re living above your means, which may not be financially sustainable in the long term.

When our income exceeds our expenses, most of us usually keep it as cash in a low-interest bank account by default. However, since our living expenses usually increase over time², the purchasing power of our saved cash automatically decreases with time. Since we can no longer purchase the same amount of stuff with it in the future as we can right now, keeping our savings as cash effectively incurs an additional hidden expense. Instead, a better strategy is to invest at least a portion of your savings in diversified³ financial assets, e.g., stocks, bonds, etc.

The fundamental equation of budgeting

Once you understand the basic components of a budget, financial planning becomes a lot easier. The basic equation of budgeting reads:

$$ \begin{equation} \textrm{Investments} = \textrm{Income} - \textrm{Expenses} \end{equation} $$

Therefore, for a given income level, if you’re trying to become financially well-off by increasing your savings, you need to reduce your expenses. If the passive income you make from your savings/investments equals or exceeds your expenses consistently, you become financially independent, i.e., you no longer need to work to earn a living. Successful investing essentially boils down to ensuring that the return on your investments⁴ is greater than the rate of increase of your cost of living over long periods of time.

Categorization

Most common budgeting tools, spreadsheets, etc. break out your income and expenses into different categories. While this is not strictly necessary, categorization can be very helpful. For example, dividing your income in various categories can show you the relative importance of your various income streams, and consider the effects of one or more of them disappearing.

Similarly, breaking up your expenditure into various categories is one of the best ways to gain insights into what you really value in life. However when it comes to expenses, it’s better to not go with the pre-defined categories that you find in most budgeting templates. Instead, it’s much better to come up with your expense categories to reflect your own individual spending patterns. For example, for some people buying clothing and accessories are an important expense item, so it might make sense for them to break it out into clothes, shoes, etc. On the other hand, some other people may not really spend much on these items, and for them, having a single category for clothing and accessories may suffice.

Your budget and your values

It’s easy to fool yourself into thinking that you’re a certain way based on how you think or act, but looking at how you spend our money can show you your true preferences.

Your budget can alert you if your spending isn’t aligning with your values, and thus, can be a valuable tool for self-reflection. For example, you may think of yourself as a budding minimalist, but your budget may show that you spend more money shopping, than on basic necessities, such as food and shelter. This would imply that you’re not really putting your money where you’re mouth is.

In summary, you can easily do personal financial planning if you understand the basic principles of budgeting, and additionally, use it to ensure you’re spending your hard-earned rem according to your priorities and values.