A friend recently told me that all he wants to know about his finances is how much money he needs before retiring. He doesn’t care about understanding his spending—or even looking at it!
He knows his spending is high today, but he believes he can reduce it at any time, and the best time seems to be retirement.
This mindset will not lead you on the path to financial success.
The Three Inputs of Financial Success
Why can’t you ignore your spending? Well, it’s a crucial part of the equation to a successful financial life:
(what we have) + (what we make) – (what we spend)
If the result is a positive number at the end of your life, you’ve succeeded!
Now, everyone pretty much knows what they have and what they make, but almost no one knows what they spend. However, you can see in the above equation that spending is just as important as the other two. In fact, it’s more important because it’s the only one you have complete control over.
What you have today was decided by your past actions. There’s nothing you can do to change history. What you make today is partly determined by your employer, the market for your skills, and a host of many other things you don’t control. But only you determine what type of lifestyle you will have and how much you spend.
Financial Success is About Control
A quick note about your emotions: They are a big part of this topic. Money can be very emotional, but spending in particular brings about many feelings— good and bad.
Many feel guilt or shame when thinking about their spending. Whatever you feel, it’s ok. Acknowledge these feelings as you reflect on your spending, but don’t let them dominate. Just like anything else in life, our feelings can guide us toward what’s best for us, but no one should make decisions based solely on them.
Instead, focus on the figures.
How to Build Your Spending Plan
Your Spending Plan will be personalized for you, and won’t be based on rules of thumb or whatever spending your neighbor is up to.
Instead, you can get a basic understanding of your current lifestyle by following the below steps:
1. Get all your spending into a single spreadsheet
For every checking, credit card, PayPal, and other account you have, download all the transactions over the past year. Then input the data in your spreadsheet. You’ll have to maneuver the data to line up the columns, but once that’s done, you’ll have an itemized list of all your spending.
2. Determine your categories
Start with a limited number of categories. I like to begin with about 15, which you will see on the Spending Plan template by clicking here. This means a lot of the transactions will go into “Miscellaneous.”
If you know of additional categories, feel free to add them, but only if they are something you want to track and control. Some examples might be clothing, wine, pets, and home improvement.
In no case should you have over 20 categories. This will make your lifestyle difficult to interpret, and the spreadsheet a real pain to update! It’s better to focus on a few areas at a time.
3. Categorize each item
Now comes the elbow grease.
After sorting the list by description, go through each transaction and enter a category. I know it’s a lot of data, but if you’ve sorted correctly, you should have all the charges grouped fairly well (all the Safeway charges are together, all your gas expenses are together, etc.).
4. Check the data
Summarize your spending by category, then confirm any numbers that look too high or low by comparing them with actual transactions. You probably won’t have bad data in your downloads, but this is a great way to solidify your confidence in the summary.
5. Build your Spending Plan
Now that you’ve confirmed your figures are correct, you know what you’ve spent over the last year. But that’s not really the value here. Remember, that’s all in the past.
The true value is in going through each category and using your historical spending to estimate your future spending. For example, if you spent $1,000 per month on groceries over the last 12 months, what is the likelihood that you will spend a different amount going forward? Has something changed? If so, how does it affect your spending?
Once you’ve gone through all the categories and assigned a figure, you have a Spending Plan!
Track Your Spending Monthly
At the end of each month, update your Spending Plan with all the month’s transactions, categorize them, and compare them to your plan. This should be a light, perhaps 5-second, analysis of your spending vs. the plan.
If you’ve created a good Spending Plan, you will definitely have some category totals that are over-plan and under-plan. That’s ok! Remember, the plan is what you think you will average over the entire year.
When reviewing your monthly figures, focus first on the categories that went over. If an immediate, acceptable reason comes to mind, feel good about that and move on. Or, if there is a reason to change the plan, go for it! It’s your plan and it needs to reflect your reality.
Second, briefly review items that are below plan and consider if your estimated spending is too high.
Don’t be surprised if the plan jumps around a bit in the first few months. This is all new to you, and it might be your first time truly understanding your spending habits.
Keep Your Quantitative Hat On
Make this exercise as analytical as possible. Plenty of emotions might surface and that’s ok, but try not to spend too much time on them. Remember, the numbers don’t change because of our feelings, they only change because of our actions.
This exercise is all about gaining control so you can spend joyously. You can only get there by understanding the numbers.
After Securing Financial Success, it’s Time for Joy
Remember the equation mentioned earlier? Once you get your Spending Plan down, you’ll be on top of all three inputs. Very few people can say that!