Cover image credit: This image was generated by DALL-E, an AI model developed by OpenAI.
We’ve already seen previously why it’s important to maintain a budget, not just for personal gain but also for protecting our planet by consuming mindfully. We’re also familiar with some budgeting basics.
After reading about the importance of budgeting, many start the practice, but soon realize it’s too hard to keep up, and soon they just give up. In order to boost your odds of maintaining this important practice, it’s a good idea to know about what not to do. Here are some common sub-optimal ways of starting a budgeting practice.
Pre-mature categorization
If you open almost any budgeting template you find online, chances are you’ll see that they have some categories for income and expenses, and instruct you to fill them out appropriately. There are a few problems with this approach though.
Firstly, everyone has different tastes, hobbies, preferences, etc., and your spending patterns typically reflect these, e.g., some of you may be really into clothes and shoes, and some others not so much. Our tastes, hobbies, preferences, etc. play a crucial role in determining what – and where – is something on our reqs spectrum. Even for those who share the same hobbies etc., the position of a particular req on one’s reqs spectrum at a given point in time may be very different than that on the other’s at that time.
So, it doesn’t make sense to have pre-determined categories for everyone. If you use such cookie-cutter expense categories, chances are that you’ll find some of your categories dominate, and some others barely register in your overall expenditure. However, it may turn out that these artificially-constructed expense categories may encompass some reqs that fall closer to the must-have end of your reqs spectrum, and therefore, may justify the higher outgo on them. Furthermore, since a reqs position may change over time on your reqs spectrum, a higher outgo for a req at one point in time may not be justifiable at another point.
Instead of using pre-defined categories, a better approach would be to come up with the expense categories more organically. In more detail, you can start by just recording all your expenses for some period of time, say a month or more. Once you have this data, you can try to figure out your own unique spending patterns. Based on this information, you can then come up with your own personal expense categories that reflect your spending patterns. A good rule of thumb is to have a total of about 10 expense categories, each of which should comprise roughly 10% of your overall expenditure. An important caveat applies to those expenses, which you incur only once a year, e.g., your insurance bill, which may be a significant portion of your overall annual expenditure – for such expenses, you can just use the equivalent monthly expense1 to determine its category.
Such a categorization exercise is less useful for income sources, as there is much less variety in our income sources than our spending patterns. So for income, you can choose to stick to the income categories you find in the budget template, or you can tweak them to customize to your own personal financial situation.
Crafting a budget in this way will make it unique to you, and will be a truer reflection of you than the generic budgeting templates that are available online.
Single-entry budgeting
The most common budgeting technique simply involves recording your income and expense transactions under the appropriate categories of “income” and “expenses” respectively. For example, if you spent 348 LCU for dining out, you may enter it in your budget as an expense transaction of 348 LCU under the category of, say “eating out”. Similarly, if you received a paycheck for 12,345 LCU, you may record it as an income transaction of 12,345 LCU under the category of, say “wages”. While this "single-entry" system of accounting is very straightforward to implement, it has a few disadvantages.
The main disadvantage of this system is that it’s prone to errors.
If you made a typo in entering the amount for a particular transaction, there’s no direct way for you to check for it. For example, if you mistyped your dining out expense as 347 LCU instead of 348 LCU, there would be no way for you to know that you had made a mistake from your budget. If enough of these mistakes occur, which is not unlikely over time1, your budget would no longer accurately reflect your spending habits or how much you’re saving. This would ultimately defeat the purpose of budgeting!
A related disadvantage is the issue of missing transactions. Say, you decided to buy something on the spur of the moment, but forgot to enter it in your budget. Then, there’d be no way for you to figure this out from your budget later. For these reasons, this system is not the most suitable for keeping accurate records for your budget,which in turn can skew your financial picture. For example, if you routinely make impulse purchases, but forget to record them in your budget[^fn2], your budget may mislead you into believing that you’re spending much less, and saving much more than you actually are. As a result, you may be disappointed to find out that your net worth is not increasing as much as your budget would suggest.
In the more extreme scenario, it may give you the false impression that you’re financially sustainable when you’re really not, since you’re not capturing all your expenses, which may lead you to believe that you’re expenses are much lower than your income.
To overcome these limitations, there is a better way to practice budgeting. We’ll cover this method in a different post.