In our hectic day-to-day lives we often find ourselves overwhelmed. With all the responsibilities we have it is no wonder that we struggle to make time or find the energy to get our financial house in order. So, why is it that so many middle class people have trouble setting aside money every month and others seem to be able to do it without a second thought? It actually turns out to be quite simple, the people who save money every month have developed automated systems to help them save a portion of their income without having to think about it. They automate their finances. This principle is often referred to as the “pay yourself first” principle.
Likely most of you have the opportunity to take advantage of an automated system to pay yourself first. Usually it comes in the form of a 401K, IRA, TSP, or some other retirement savings account. However, the people who have truly mastered this take it one step further and setup their own automated savings for big expenses like buying a house or car, paying for medical expenses, or family vacations.
But Phillnance, how can I do this? I’m glad you asked make believe blog friend! The trick is to use our own psychological weakness in order to do something good for ourselves. In Nudge: Improving Decisions About Health, Wealth, and Happiness (click link to order) a book by Nobel laureate Dr. Richard Thaler, Thaler discusses how we humans have an overwhelming tendency to accept the default option. Thaler discusses how companies and governments have been using this psychological lever to influence people for a long time. So why don’t we use it on ourselves to improve our own circumstances?
Now that we understand our predisposition, let’s get into the practical steps we need to take to make it come true. I think it helps to start with an example. The diagram below shows how I have setup my personal accounts to automate my savings.
There are a few important things to point out here that may not at first seem obvious. The first thing is that many of these accounts are actually with different financial institutions, but my savings, checking and money market accounts are at the same institution for ease of transferring money. I want those accounts to have little to no delay when transferring funds because almost all of my typical monthly expenses will flow through these accounts. The second thing to note is that I determine how much money can flow to my checking account every month, the account I spend from. Why do I do this? Because I want to make a conscience decision about how much money I spend every month. From time-to-time a big expense comes up and I have to dip into my money market account to cover the bill, but even this requires me to go in and transfer the exact amount I want between accounts. Finally you will notice that I have five different accounts to hold money in for savings purposes and only one account to spend from. I keep multiple accounts of this nature because they each have different characteristics I find useful from tax advantages to ease of use they each have their place and I encourage you to learn the advantages of each. The important thing is that three of the five accounts are at different financial institutions from my checking account. What that does is it prevents me from dipping into money I am setting aside for medical bills, retirement, saving for a house, etc. and forces me to be disciplined with my money. The money is far enough out of reach and out of sight that my cognitive bias towards the default allows me to find other ways to solve the problem instead of spending the money.
In all actuality my account setup is a bit more complex than this but this diagram has all the main features. I left-out all of my joint accounts with my wife, which I highly suggest setting up at least a joint savings and checking account for any married folks out there, and it also leaves out the the fact that I have multiple retirement accounts (one for each of my past employers).
Please keep in mind that the most important thing is to pay yourself first – every month. Determine the amount of money you want to save every month and automate it so it comes out of your paycheck and savings account directly thus taking advantage of our predisposition to accept the default. Once you have the structure in place and have it automated you can start to fiddle with saving more money every month which is one area that most people in the U.S. do a poor job at – no pun intended.
As a friendly reminder, the good economists at Stanford recommend that you save 10% to 17% of your money into a retirement account if you start saving at or before 25 years of age in order to have enough money for retirement by the time you are 65. That is to say nothing about what you will need to save beyond the 10% to 17% to be able to afford a down-payment on a house, buying your next car, sending kids to college, etc.
Nudge is one of my favorite books because it takes behavioral economics and breaks it down in a way that makes it easy to understand. One of the more compelling examples of its power is a case study in how different governments have used our psychological tendency to accept the default to significantly increase organ donations. It is a great read and I implore you to check it out if you are at all interested in behavioral economics.
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