Imagine for a second that when Goldilocks came across that hut in the woods, instead of finding 3 bowls of porridge, she found 3 slices of toast with peanut butter. The first slice had way too much, the second had too little, and the third was just right.
Now step into Goldilocks’ shoes and replace the toast with your financial goals and the peanut butter with your money and assets. Achieving the optimum thickness of peanut butter on each of your toasted targets is vital if you are to maximise your financial utility.
In case you haven’t quite figured out what my breakfast based analogy is referring to, today we’re going to examine the process by which you allocate your resources to hopefully work out how to hit that sweet spot.
What Goes Where And When?
With myriad saving goals established across a range of time frames, deciding how to split up your income to achieve each of them poses more than a few problems. Is the dog’s hip operation more important than sending your child on a school trip? Should you be saving for a house or investing in a pension? Should you install solar panels or convert the attic? These are the sorts of predicaments that we may find ourselves in, but how can we go about deciding where our money should go?
The first trick is to assign a score to each of your options based upon how important it is to you. So the health and well-being of the family pet will probably be more important in the short term than putting money aside into a pension or making home improvements, so it should score highly.
Don’t, however, fall into the trap of only considering the present moment when calculating your scores. Just because your retirement might be a long way off, it doesn’t necessarily mean that making provisions for it shouldn’t rank towards the top of your list.
For items where there is a deadline for the money to be saved, note this down on your list, or if they are longer term visions, mark them as such. Based upon the scores and timeframes you’ve come up with, you can start to allot amounts to go into each pot. This exercise should be carried out once a month to enable you to budget accordingly.
Say that your car breaks down, for example. Assuming that it needs to be mended urgently because of its importance in getting you to work, it can be assigned the highest possible score. To counter this, you might reduce the score associated with your leisure activities that month.
One of the beauties of life is the degree of unknown, so think of your scores as fluid and flexible to a certain degree; don’t be afraid to change them from month to month.
Think About the Future
The second principle to efficiently apportioning your money is to consider the future value of your spending today. In other words, try to work out how your choices will impact your prosperity in the months and years to come. Maybe putting all of your effort into saving for a deposit on a house will allow you to escape the current high rents you are paying sooner; in which case you might forego a holiday this year knowing that you’ll be able to afford more holidays in subsequent years.
There is a certain skill in figuring out the future value of expenditure in the present because not only do you have to consider the interactions that can occur, such as the example above, you have to factor in things such as inflation, interest rates (or any other form of investment growth), and compounding among other things.
A dollar saved into a pension today might be worth many times as much upon retirement thanks to compound interest. Or you might think it’s a wise decision to buy into gold, but its value can vary significantly over time and it could be that your investment is not worth as much as you had hoped when you come to liquidise it.
Separate the Savings
The third tip to ensure that you are managing your budget effectively is to use distinct accounts for each of the major things that you need to spend on. While it may not be practical to have your money in 10 different places, for the biggest savings goals such as a home deposit, car, or a child’s college fund, there are benefits to segregating them.
For one, when the money is separated like this, it is easier to understand how much has been saved towards each target. Were it to all be pooled into a single account, knowing what’s what can prove much more difficult.
A second benefit of splitting things up like this is that the temptation to spend the money that has been saved for a specific purpose is less. Once you have transferred that month’s sums from your main pot to the individual accounts, you have a better understanding of your remaining budget and won’t be so easily persuaded to dip into other funds.
Locating the Goldilocks Zone
In Astronomy, the Goldilocks Zone refers to the range of positions a planet can be in around its star for the potential for life to exist. Too close or too far away and the chances are virtually zero.
With your personal finances, there is a similar zone corresponding to the amount of money that is saved or spent towards each of your needs and goals. Based on the 3 principles above, you should now be in a position to figure out how best to spend and save the money that you earn. It will take a bit of juggling at times and the process will constantly evolve, but by efficiently allocating funds, you can be a better saver, a better investor, and a more astute consumer.
Your own Goldilocks Zone won’t mean life or no life, but it can impact your experience of life by relieving stress and providing a more comfortable and fruitful existence in the long term.