Four skills you must understand and practice if you hope to achieve financial independence.
I have a little slideshow I use when I teach a class. It provides the students/audience with something to look at other than me.
On the very first slide are my Four Basic Principles of Personal Finance:
- Spend less than you earn.
- Understand and identify your needs vs wants.
- Practice delayed gratification.
- Let. Money. Sit.
At first glance, these rules are ridiculously basic. Simple, even. Laughably simple? Yes. But each one has multiple layers of complexity once you start taking a closer look. I’ll overview my four principles now, just as I would at the beginning of a lecture; expect some deeper digging in future articles.
Spend Less than you earn
The first principle, Spend less than you earn, is such a basic rule of finance that I’m always a little embarrassed to even mention it. And yet it never fails to elicit the kind of sounds that people make when they’re hearing, or at least understanding, something for the very first time. This concept is also referred to as living below your means.
In order to even merely keep up on the hamster wheel of a paycheck-to-paycheck existence, much less get ahead, one must spend less than they make.
So you add up your rent or mortgage, your car payment, throw in a little food, gas, and maybe some fun money and compare that to your monthly salary and clearly your expenses are less than your income so you’re good on this point, right? Wrong!
It’s not enough that your basic monthly expenses be less than your monthly income. Over the course of an entire year, your total outflow must be less than your net income. That means that in addition to your monthly bills, you also have to consider annual expenses, one-off purchases, the unexpected, and emergencies. In other words, not only must your income exceed the total cost of rent, food, and fuel, it must also exceed what you spend on your regular dental appointments, new tires or repairs on your car, additions to your wardrobe, and your annual Amazon Prime membership.
Understand and Identify Your Needs vs Your Wants
I believe that quite probably the number one cause of fiscal instability — what I’ve witnessed over and over again in clients, family, and close friends — is a complete disconnect to the concepts of Wants and Needs. Without a strong sense of what we need as opposed to what we want, it’s impossible to be in control rather than being controlled by our financial situation.
That is not to say that there is anything wrong with having wants. Nor does it mean that we can’t or shouldn’t indulge in those wants. Quite to the contrary. I’m a big fan of Wants; they can be a very powerful motivator. But if we cannot step back and say, “wow, I really want that” as opposed to, “oh, I need that”, we are doomed to have no more control over our finances than a 3yo has over her emotions.
Practice Delayed Gratification
Delayed gratification is the next step beyond being able to identify Wants versus Needs. The ability to use accurate and honest language within our internal dialogs (being able to say, “oh, man, I really want that” instead of convincing ourselves “I really need that”), is a function of delayed gratification.
If you were not born with a strong and innate ability to delay gratification, don’t beat yourself up. The vast majority of us are not naturally “high delayers.” But the ability to delay gratification is a muscle almost anyone can develop — it’s all about finding the technique that works best for us.
There have been many fascinating studies on delayed gratification (a subject I’m sure to write on further) and one of the generally accepted conclusions is that people are generally more motivated by potential loss than by unguaranteed gains. That means that if you can associate a delay with a loss, you’re much more likely to be successful in the delay.
Think of it this way, you’re more likely to be able to forgo your morning latte if you can directly associate the purchase of the latte to the loss of a much-desired evening out than if you associated no latte with potentially having more money left at the end of the month.
Let. Money. Sit.
I believe this is far and away the least possessed money skill in our [American] society (I can’t speak for other nationalities). I have a number of theories on why so few of us possess the ability to let money just sit but those are for another day and time. For now, we’ll just look at the principle itself.
We all know that guy who simply can’t keep $10 in his pocket. Indeed, we refer to this as money “burning a hole in our pocket.”
For some of us, the situation isn’t too terribly extreme. We manage to save up enough to have a nice little cushion in our savings account. Still, that savings account never seems to fill up past a certain level. The threshold might be a lot higher for some than others but the inability is the same; when we get to the point where we have an extra stash of cash, some burning need or desire presents itself and since we have the cash on hand, why resist, right?
Whether it’s $10 and the ability to resist temptation to enjoy a meal out goes up in smoke or it’s $2,000 and the flatscreen TV that we’ve been lusting after becomes the only thing we can think about, the effect is the same. Being able to sit by as our bank balance grows beyond a familiar threshold without manufacturing a reason to spend is a skill that can be surprisingly difficult to master.
These are my four basic principles of personal finance. All four are necessary in some measure to be an effective manager of your money. A certain level of mastery is necessary to achieve financial independence. Most of us have at least one principle in which we have much room for improvement. Which of these four principles is your weakest?