Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

In earlier chapters we established that pillars are funded by monetizing your human capital. The size and health of your pillars depends crucially on your ability to consistently make money and contribute it to building assets.

In this chapter we discuss budgeting, which involves tracking earnings (income) and expenses over a given period.

In a year when your earnings are greater than your expenditures, you have money left over to invest (contribute to pillars), but when your expenditures are greater than income, you have to fund the shortfall by taking on more debt or by using up some of the value in your pillars. Shortfalls destroy value rather than creating it.

Consider this simple example. Your annual household income (from all sources) is $120,000 and your annual expenses (rent, food, car, etc.) total $110,000. The difference between these two numbers is your household net income = $120,000 - $110,000 = $10,000. If your household was a corporation we would call this excess amount “annual profit.” Now imagine that you can generate this much excess profit every year for thirty years and you invest that excess in stocks. Per our earlier time value of money discussion, if you average an 8% annual return on these investments, your cumulative nest egg after thirty years would be over $1.2 million. If you invest $20,000 annually the nest egg would be over $2.4 million. Add to that the value of your home and you can easily be looking at a total worth of $3 million.[1]

Now consider a scenario where your total income is $120,000 but your annual expenses total $130,000. Instead of a positive net income (profit) you have a negative net income (loss). Rather than put money into pillars where it can compound and grow, you must take money out of your pillars, depriving your nest egg of these amounts and all the growth they would have generated in your pillars over time.

There are 3 possible budget outcomes:

1. Total Income > Total Expenses     (i.e., Net Income is positive)

Living below your means. Your income exceeds expenses (household makes a “profit”), leaving you with money to invest or pay off debt. This is the ideal situation.

2. Total Income = Total Expenses      (i.e., Net Income is zero)

Living at or within your means. Your income equals expenses (household “breaks even”). This is an acceptable situation, as long as your budgeted expenses include contributions to retirement accounts and other needed savings.

3. Total Income < Total Expenses       (i.e., Net Income is negative)

Living beyond your means. Your expenses exceed income (household “loses” money). This is an unacceptable situation, as it steadily destroys your pillars over time.

Living beyond your means is devastating to your household’s financial well-being and must be avoided. 

Always strive to live below (or at least within) your means! You can achieve this by ensuring that each year your total income is greater than total expenditures. Steer the excess into pillar-building and or debt repayment and you’ll be in good shape.     

 


[1] Technically, the value of a primary residence is often omitted from net worth.


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