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A FAVORITE QUOTE in the world of personal finance comes from Ernest Hemingway’s 1926 novel The Sun Also Rises.
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, then suddenly.”
Money troubles are a common theme throughout literature. Charles Dickens probably summed it up best. In David Copperfield, a fellow named Micawber laments: “Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
The message: Overspending is probably the quickest route to financial unhappiness. That’s hardly new information. A new study, however, sheds further light on this topic. Titled “Understanding and Neutralizing the Expense Prediction Bias,” the research explores a question that’s often overlooked: Why do people overspend? The study uncovered an interesting explanation.
In their experiment, the authors asked people to estimate what their spending would be over the coming week. At the end of the week, participants reported their actual spending. The result, as you might guess: The subjects regularly underestimated their spending—by 12% to 25%, on average.
They repeated this for four weeks, and each week the results were about the same. Then, for the fifth and final week, the subjects were split into two groups. The first group was asked to estimate their spending just as they had in prior weeks. The second group was given an additional prompt: They were told to think of three reasons why their spending in the fifth week might end up higher. They were given examples, such as an unexpected car repair or a medical bill.
That made all the difference. At the end of the fifth week, the first group continued to underestimate its spending. But the second group—the one that received the additional prompt—ended up with much more accurate estimates. They actually overestimated their expenses by a hair.
The conclusion: In estimating their spending, people have a good handle on their fixed expenses—things like rent, mortgage and car payments. But they overlook expenses that are more variable.
I’m not surprised by this finding. In my experience, most people have a hard time estimating their household spending. Despite all the tools available to track expenses—from Quicken to Mint to YNAB—it turns out to be a task so difficult and so tedious that many simply give up.
Even though Quicken and its peers have advanced over the years, the reality is that the problem’s complexity has advanced faster than the solutions. In the old days, families might have had one bank account and maybe one credit card. But with the allure of rewards points and discounts, the number of credit cards in many people’s wallets has multiplied. On top of that, we have money coming and going through services like Venmo.
The growth of subscription-based services has also contributed to the complexity. It’s led many to feel out of touch with their own finances. In the past, money didn’t leave our bank accounts unless we chose to pay a bill. Today, that balance of power is reversed: If we don’t want to continue being billed automatically, we have to navigate a company’s website or 800 number to request that the service be canceled.
The result: Most people today can tell you generally whether their income exceeds or falls short of their expenses. But beyond that, most are hard pressed to provide a specific number. Fortunately, there are solutions.
The gold standard is to hire a bookkeeping service. But that’s a step most people aren’t willing to take. In addition to the cost, many folks justifiably worry about the risk of fraud, and they’re uncomfortable allowing anyone else such a detailed look at their finances.
There are other approaches. While software works for many people, it also requires a fair amount of babysitting to download and check the data. An alternative, ironically, is to rely on old fashioned bank statements. Even if you don’t receive them in the mail anymore, you can download them from your bank’s website.
Right at the top, they’ll usually provide a total of all the dollars that came into your account and all the dollars that went out. Without worrying about all the individual transactions, these summary numbers can provide a good understanding of your income and expenses. Even if a lot of your spending is on credit cards, this strategy can still work as long as you pay your credit card bills from your bank account.
Beyond the obvious, what’s the value in having a more detailed picture of your expenses? I see several benefits. First, if you’re in your working years and looking ahead to retirement, it’s important to estimate what I call “core expenses.” These are the expenses that will be with you in retirement. For most people, that will be a different, and lower, number than during their working years.
For example, in retirement, your mortgage might be paid off and, if you have children, they’ll likely be out of the house, out of school and on their own. If you have a reliable breakdown of your expenses today, that will allow you to identify and total up your core expenses. You can then use that number to calculate a savings target for retirement. By comparing that target to your current savings rate, you’ll know whether you need to make a change in your spending.
You would, of course, want to make a change if you discover you aren’t saving enough. That’s clear. But there’s a more subtle problem that affects some people: They’re saving too much—and unnecessarily spending less than they could. Some people do this simply out of habit. Frugality is in their DNA. I suppose that’s okay. But other people spend too little out of fear. Because they haven’t done the math, they don’t realize that they could be spending more. For those folks, running the numbers can help them relax and enjoy life more.
Having a good understanding of your expenses can also help you prioritize. One fellow I know charted his spending using a Pareto chart. Named for the Pareto Principle—often called the 80-20 rule—a Pareto chart makes it easy to see which expense categories really matter. In other words, if you were looking to cut your expenses, a Pareto chart would clearly indicate where to start. If your dog groomer seems expensive, for example, but he accounts for less than 1% of your budget, it’s probably not worth looking for a replacement. Instead, you’d want to use that time to hunt for even a small percentage savings in one of your larger spending categories.
Accurate spending information also carries benefits for retirees. On the one hand, you want to avoid depleting your assets too quickly. On the other hand, if your assets have grown, you may realize that you’re in a position to spend or give away more.
A final benefit—one that’s especially helpful during periods of financial uncertainty such as 2022: Any information that can provide a greater understanding of our finances, and thus give us a greater sense of control, can be invaluable. Unlike all of the things outside our control—including the stock market, inflation and geopolitical worries—our own spending is a lever that’s well within our control. Even if we don’t make any changes to our spending, there’s a sleep-at-night benefit to simply having this information.
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 have never heard of the pareto chart, so thank you for that. the groomer example is great and gives me a chance to throw a flag on the play. my dog’s nails grow faster than a kid going thru keds… she gets her nails done every 4 weeks/$20 and i can well afford it. it is a sneeze in my line item over all budget and is a % pittance. that being said, it has not set well with me and i found a groomer that does the same job with the same results [and a biscuit at the end] for $5. as mark twain famously said, put all your eggs in one basket, then watch that basket! i watch every expense, but do not put savings over the job/product. i just believe a budget is ongoing and savings ANYWHERE add up to savings EVERYWHERE.
I am in my second year of using Tiller, and it’s helping me see how much I am spending. It may help some of your readers.
Even using Quicken or other software it’s still challenging to get a good estimate of average annual spending due to lumpy expenses. Home maintenance bills can be large but infrequent. And cash-flow budgets miss the lower annual cost of goods that last many years. For example if you get a new TV you might expect it to last a decade, but in the year you purchase it your spending on electronics will look artificially high.
Dickens was right as far as it goes. Earning 20 and spending 19 and 6 keeps you out of debt. That’s sustainable indefinitely and no bad thing. Until you retire. Then, saving only 3% over your working life could result in a pretty austere retirement (at least here in the US).
So overspending for someone who aspires to retire in their early 60s, for instance, is not only spending more than they earn. It’s spending so much that they’re not able to save adequately.
Thus, there are really two problems with overspending. First, it’s going into debt – running up credit cards and paying monthly interest on it is a ruinous hole to get into, and can be difficult to get out of.
Second, adopting a ‘maximum’ lifestyle that uses up most of what comes in means you’re not saving for retirement.
My advice:
BTW, I agree with the economists. You don’t necessarily have to worry much about saving anything and tracking all that until you turn 40 (about what I did). Then start tracking all of the above and save like mad when you’re finally earning the big bucks.
How about this? NI-S=S. Net income minus savings = spending (no charge not paid in full at end of the month). Impossible to overspend and after a couple of months it becomes automatic.
I agree 100%, though I call it “Profit First” from the excellent book of the same title:
This is a really helpful framework for me. Cause I think I fall into the category of maybe over saving. I’ve been using my current expenses as the baseline estimation cost. However, knowing that I might have a family in the future it’s hard to not use my current expenses because I know my lifestyle is probably gonna inflate as more responsibility is added. But this is good to know for future me.