Financial Behavior: What You Should Focus On And Why
Let's talk about your financial behavior and why it matters. When I work with clients, we focus on what you can control vs. what you can't control. You can't control what the markets will do this month, this year, or even tomorrow! Here's what you can control:
1. Your own spending rates
2. How much you save
3. Your financial safety net
4. The amount of risk you take
Let’s dig into each of these areas.
When talking about spending, we divide the world into discretionary expenses (those you have some control over) and non-discretionary expenses (those you can't cut back on, at least in the near term). Discretionary expenses are things like spending on restaurants, travel, entertainment, and non-essential shopping. Non-discretionary expenses include rent/mortgage, debt repayment, groceries, and medical expenses. Cutting back on your discretionary spending is a straightforward concept, but it is far from easy! Sometimes just tracking expenses for a month is an eye-opening experience. That alone often inspires people to cut back on some spending. Taking a deliberate approach to your spending can help ensure you are spending money on what matters most to you and not just buying out of habit.
Your savings rate is obviously closely related to your spending rate. If you are spending more than you bring in each month, there's nothing left over to save! Once you have a good handle on your spending and can divide your expenses into discretionary and non-discretionary, you can start to figure out how much you can save each month. More than almost any other factor, your savings rate will determine your future financial health.
By safety net, I mean planning for emergencies. Life insurance and disability insurance fall under this category and are important parts of a comprehensive plan. If something happens to you, you'll want to be sure those who depend on your income will be taken care of. The other category that falls under "safety net" is having an emergency fund. If you've worked with me or read my prior writings, you know that I actually break down the emergency fund into two distinct funds. One is your "pure" emergency fund. This is for the big emergencies like job loss or serious illness. I hope you'll never have to touch your pure emergency fund once it's in place!
The other kind of emergency fund is for the unpredictable but inevitable expenses that pop up and cause cash flow problems if you haven't planned for them. This includes everything from car repairs to home maintenance to an unexpected invitation to a destination wedding that you feel obligated to attend. You'll want to set up an automatic contribution to this fund every month. Then you'll be pulling from this fund when these inevitable expenses arise.
If setting up multiple savings accounts and moving funds in and out sounds like too much trouble, there’s a budgeting tool called YNAB (You Need A Budget) that allows you to do the same thing, but with just one savings account. It lets you to designate what the dollars in your savings account are being saved for — car repair, appliance replacement, home improvement project, etc. I’m a huge fan of using YNAB to track your unpredictable but inevitable expenses.
By risk, I am referring to the amount of investment risk you take in your portfolio. We can divide the world of investments into two broad categories: stocks and bonds. If 100% of your investments are in stock funds, your returns will likely be very volatile. Some years your funds might be way up. Other years they could actually have negative returns. Bond funds on the other hand, typically are less volatile (they tend to go up and down less than stocks funds) and reduce overall risk in a portfolio, albeit with lower expected returns. So, based on your timeline (how long before you plan to use the funds) and your tolerance for risk, you'll want to choose a ratio of stocks to bonds that sets you up to hit your long term goals without taking on more risk than is necessary.
The best way to determine your tolerance for risk is to use an assessment that has been tested and shown to be reliable and valid. My clients complete a risk tolerance assessment, then we use these results along with conversations we have about their goals and understanding of investing to determine the best mix of stocks and bonds for them. If you want to test out a shorter version of the risk tolerance assessment tool I use, follow this link to get your own results.
Financial Behavior And Controlling What You Can Control
Just because we are able to control these areas (spending, savings, safety net and risk), it doesn't mean that controlling them is easy! This is where your own behavior has a huge impact on your plan. Above all, it is what we spend, save, and invest (again, our behaviors that we control) that determine the success or failure of any financial journey.
In fact, research has shown that saving behaviors are more significant in terms of their impact on overall financial success than even investing-related behaviors. This Vanguard study, particularly the final page, paints a stark picture of the importance of saving for financial success. The bottom line? Nailing down the basics of financial behavior is critical.
Again, just because we know that savings rates play a huge role in the overall success of your plan, that doesn't make it any easier. Human behavior is hard to change! There's quite a lot that goes into how we save and how we can improve in this area. Or put another way, it's not just one area of financial behaviors that matter. It's how our consumption habits are affected by our environment — in other words, how confident we are in our financial decisions and whether we are easily distracted that also impact our financial outcomes. Research has shown that a consistent pattern of effective financial behaviors is a more important factor in determining your net worth than age or income level.
So how can you improve your patterns of financial behaviors?
- First, set your financial goals!
- Identify where you are today. What behaviors are holding you back from achieving your financial goals?
- Acknowledge that work is needed. To improve in any behavior, work & commitment is required.
- Finally, create a plan and get support. Work to develop better behaviors in specific areas. Here’s where working with a good financial planner can be extremely impactful.
When I work with clients, we always start with a financial profile assessment to learn about their attitudes and behaviors around money. You can click here to try an abridged version of the assessment I use with clients. I also go through a "Money Story" discussion with my clients at our first data gathering meeting. I can't help my clients with their finances and behavior without understanding how they got to where they are and how they formed their beliefs about money.
For my ongoing clients, we'll come back to financial behaviors each time we meet. Setting up habits, automating your finances and building successes are all part of the process. Working with a financial planner is similar to working with a personal trainer. We all know what we need to do to get fit, but most of us aren't able to stick with a fitness routine on our own. Same goes for becoming financially fit. Most people know what to do to become financial fit, but the hard part is actually making it happen. As a financial planner, I serve as the accountability partner - the objective third party helping my clients stay focused on their goals in order to build wealth and gain financial peace of mind over time.
I meet with my clients 3 times in the first two to three months to gather data and build a plan that sets them on a path toward success. Some then implement the plan on their own and set up an annual "tune-up" meeting to make sure they are implementing the plan. For others, it makes sense for us to work together on an ongoing basis. In that case, we'll meet in person (or virtually) twice a year, but we'll have plenty of emails and or phone calls in between to make sure you are hitting your goals and to address other issues as they come up in your life.
Most people think the specific investments they choose are the main decision they’ll be making when they work with a financial planner. But while investment choice is obviously important, there is a whole lot more involved. It’s your behavior - specifically in the areas of spending, saving and investment allocation that will have the biggest impact on your financial health. That’s where a good financial planner truly adds value. If you’d like to learn more about working with me, please follow this link to schedule a free consultation call. If you are ready to take control of your financial life and take the first step toward a better financial future, I would love to be your guide. Let’s talk!
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Alyssa Lum, and all rights are reserved. Read the full Disclaimer.