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I’VE TALKED IN EARLIER articles about asset-liability matching. It’s a concept popular with insurance companies to manage investment risk. It’s a very formal approach and not one I would expect an individual investor to follow too literally. But it’s a notion that, in general, can help individuals make asset allocation decisions.
In his book, The Outsiders, William Thorndike highlights another well-known principle in corporate finance that can also be applied to personal finance: It’s called capital allocation.
Capital allocation refers to the choices that managers face in allocating corporate profits each year. In general, companies can allocate cash in one of five ways:
Because there are so many possible ways to use their cash, companies will often develop a policy for guiding these decisions. Procter & Gamble, for example, tends to allocate 5% of revenue each year to capital projects—new factories and the like. Then it allocates $9 billion to dividends, and between $6 billion and $8 billion to share repurchases. If you examine the company’s cash flow statements, you’ll find that these figures are fairly consistent from year to year.
If this seems like a topic that we don’t hear much about, you’re right. It isn’t the most interesting area—even for corporate executives themselves. As far back as 1987, Warren Buffett called out fellow CEOs for not paying enough attention to capital allocation. “It’s a critical job,” Buffett said, but “plenty of unintelligent capital allocation takes place in corporate America.”
In his book, Thorndike confirms Buffett’s assertion that capital allocation is critical. The Outsiders looks at a group of extraordinarily successful companies. A trait common to all of them, as you might guess, is a wise approach to capital allocation.
Like asset-liability matching, capital allocation is a very formal approach to financial management. But there are ways in which individual investors can borrow from this idea to better manage their personal finances.
Most important, thinking in terms of capital allocation can help break the logjam many of us face when the word “budget” is mentioned. The reality is that, despite all of the budgeting tools now available, no one really enjoys it. And the task has only gotten harder. These days, money is moving in more directions, making it harder to track. In addition to cash, checks and credit cards, there are now apps like Venmo. If you’re like most people, a proliferation of little monthly charges also hits your checking account each month.
All of this makes budgeting seem more elusive than ever. The result: Many families today have only a general sense of their monthly spending. This isn’t good for long-term planning and, in the short term, it can lead to anxiety.
That’s where capital allocation can help. It can free you from the Herculean task of trying to track every little expense—a task so unrealistic that, in my experience, I have seen only two families ever really accomplish it. Instead, a capital allocation approach to budgeting would allow you to think about spending in an entirely different way. Below, for example, is a framework that a young family might use. Notice the very broad categories:
What about an older family? Here’s what its framework might look like:
At first glance, you might wonder what benefit these simplified categories would really offer. After all, as I mentioned above, the challenge is that money is going in too many different directions, making it difficult to track. Whether we use five categories or 50, that data still need to be tracked.
That’s where capital allocation can really pay off. Instead of trying to track every transaction the old-fashioned way, capital allocation takes an entirely different tack. What you want to do is to rearrange your finances such that budgeting becomes automatic. Below are a few ways to accomplish this. Note that these are just examples, and there’s no need to cover every last dollar. You might try some of these techniques, and then modify them to suit your needs.
Split paycheck. If you’re in your working years, you can ask your employer to split your pay among more than one bank account. This should be simple enough for your employer’s payroll processor, and it’s the easiest way to divert money away from your day-to-day checking account. If you have a retirement account like a 401(k), you’re already doing a version of this, and I’m sure you’d agree it’s very effective.
Earmarked accounts. The next step is to earmark each of your bank accounts for specific purposes. For example, you might have one account for fixed monthly expenses and another for discretionary. You would then use a debit card tied to your discretionary account at Starbucks, at restaurants and so forth. The advantage of this approach: If you allocate a fixed sum into this account from every paycheck, you won’t need to track every little expense. Instead, you can simply use the account’s balance as a barometer to tell you where you stand relative to your budget.
One common question: How many separate accounts should you have? Since the objective here is to develop a system that’s easy and automatic, you want to keep things as simple as possible. As a rule of thumb, you might aim for just a small handful of accounts. In the example above, you’d have just two. You might consider a third, earmarked for subscription services, which have a habit of quietly building up over time.
Another common question: It seems like there could be a chicken-and-egg kind of problem here. If you don’t yet know how much you’re spending in each category, how would you know how much to allocate to each account? That’s a fair question, and it is a bit of a trial-and-error process to gauge the right amount. The good news: A benefit of this process is that it’ll help you identify those figures without the tedium of trying to total up every minor expense.
In retirement. If you’re retired, this approach can work equally well. Instead of allocating your paycheck among accounts, you would instead allocate scheduled monthly transfers from your investment accounts. A key additional benefit of this approach: Instead of viewing your investment portfolio as a sort of bottomless resource—which can be a risk when one’s entire life’s savings is a few clicks away—this technique can help you gear your spending to a predetermined withdrawal rate.
Major purchases. To borrow another concept from corporate finance, it’s helpful to accrue cash in separate accounts for significant purchases. Suppose you want to allocate $10,000 for family vacations each year. Instead of raising these funds in an ad hoc way when the vacation bills arrive, you could instead set up regular deposits into a vacation account, so the funds are there when you need them.
Charitable giving. For charitable giving, donor-advised funds can be very tax-efficient. They also work well with a capital allocation approach to budgeting. Suppose you like to donate $5,000 to charities each year. If that’s the case, you could transfer that sum all at once—perhaps in December of each year. Then, throughout the year, you could use the tracking tools built into the donor-advised fund’s website to see where you stand relative to your annual target.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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I’d recommend these allocations:
Yes, that’s my actual budget. Very few people should aim to pay off student loans aggressively when there is income-based payment available, and remote workers can cut housing and transportation way back.
Excellent thoughts here. Been doing a similar things for years with multiple sinking fund accounts for Gifts, Saving, Auto Repair/Fuel, Newer Auto, House/Mx, Travel/Vacations, Food-Groceries. We also have cash in pouches where one doesn’t need a receipt; it’s just we get so much/month for various things like clothes, hair care, discretionary. We’ve been rather successful using it and yes, we make adjustments as inflation, other things change on us. It has made us more thrifty, we see where money is going, and if something happens (unexpected car repair, plumbing issue, etc.) we go there to pay for it. Yes, one must be disciplined, but it works for us.
I must be one of the of the few but I literally track every dollar spent. I get notifications on my phone whenever money is spent and how much. I log open my google sheet and update the document. It takes seconds and I always know where we are financially. It brings me peace and works well for my family
An interesting article with a number of useful options. I use a variation that combines elements of some of the options. I keep a lot of cash in my checkbook (partly to qualify for lots of free banking benefits, a separate issue.) I use my checking account mainly for all of my usual and expected expenditures, whether utilities, food, entertainment or Home Depot. (I even leave room to include occasional bigger expenses in that pot, like a new water heater or lawn aeration/seeding.) I have set my automatic deposits each month at a level that I have found roughly offsets all those expenses. Then there are the special expenses: My largest expenses are Federal and state estimated taxes, real estate taxes and gifts to charity and my kids, and so I treat them as “extraordinary”, and I move money to my checking account each time I have to make one of those larger payments. What I have found is that by looking at my checking statement each month, I can tell whether I am above or below my financial “sea level”. At the end of the year, I look at the “flow” and decide whether I should alter my automatic deposits or not. This method is more “seat of the pants”, but it really works without needing multiple accounts or detailed accounting.
Very glad to read this Adam. I have been advocating and following a similar approach for years. A couple of years ago I outlined our personal strategy on HumbleDollar
You’re right, for the first several months the allocation is trial and error, but then it becomes routine with perhaps minor adjustments year over year. For example, this year because we couldn’t take two planned trips, we used the “travel” account for remodeling. But we are back to travel allocation again.
Detailed budgeting is stressful, unnecessary and the longer the budgeting period the less accurate it becomes, which is especially the case for retirement planning IMO.
Thanks for a very helpful post, Adam. I’ll make my usual semi-regular plug for using Quicken for this exercise. Quicken comes out of the box prebuilt with the standard consumer expense categories (which can be edited down / renamed easily). Our purchase / deposit transactions automatically download into Quicken from our 3 bank accounts and investment account values are also updated after I log into the app each day.
I really like their recently added “tags” feature (used to further “bundle” specific types of expenses for searching purposes), by employing a “capital allocation” category list similar to the one you referenced in the article – though we have added three more to our family’s list: food, insurance and taxes.
Though we aren’t hard-core budgeters, Quicken’s robust reports feature allows us to easily compare spending by category YTD vs. prior YTD (or compare various other periods) – which is something that we’ll typically review once a quarter as a family. As you referenced in the article, the pervasive nature of recurring monthly subscriptions (Netflix, Apple Music, et al) is indeed, quite the eye-opener on a year-over-year basis.
In short: In order to know where we are going financially, it is exceptionally helpful to first know where we’ve been…
Why do you need all that information? What do you actually do with it? Just curious.
With my wife and I being both self-employed, our HH income can vary greatly based on market cycles, etc. on a year-to-year basis. Likewise, the number of children who still rely on our parental support has sometimes varied (so much for the empty nest!).
A baseline of where we were in the prior quarter / year is helpful – it provides us some needed context on where to make tactical adjustments financially.
It’s not always a decision of “cutting specific expenses” that results. Sometimes it’s about putting more emphasis on what areas of our work income are getting the best ROI (time invested versus income derived) vs. prior years.
For us at least, playing good offense (income) and defense (expenses) are equally important. It’s a well-calibrated balancing act.
I really do like the “buckets” approach to saving up for different things in different accounts.
Economists will argue this is illogical because of the fungibility of cash. (Every dollar should be used in a way that maximizes utility, and bucketing is an inefficient way to do this, they might argue.)
However, humans are not robots and it makes things immensely easier to have “buckets”, including this very logical and easily-comprehensible capital-allocation bucket system.