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.