Based on the principles and research in personal finance, this article delves into effective strategies to manage and save your money. Through an understanding of various articles and studies, it outlines ways to promote financial health and grow wealth over time.
In today’s world, managing personal finances efficiently has become increasingly vital. This understanding of financial management goes beyond mere saving; it encompasses budgeting, investing, and planning for future events (The Balance, 2021). Sound personal finance habits are linked to reduced financial stress, improved quality of life, and a sense of financial security (Joo, 2008). This article is a comprehensive guide to understanding and implementing methods to save money based on various studies and reliable sources. It will also delve into the role of behavioral finance in saving money, highlighting key concepts that influence our financial decisions.
Understanding Personal Finance
Personal finance refers to the management of financial resources and decisions, including income generation, spending, saving, and investing (Xiao & Olson, 1993). Fundamentally, it is a balance between inflows and outflows. Effective personal finance management necessitates thoughtful budgeting, goal-oriented saving, wise investing, and judicious spending.
This foundation is critical because it is the baseline upon which we build our discussion on saving strategies. Furthermore, in the words of renowned financial author Robert Kiyosaki, “It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for”.
Establishing a Budget
An article from The Balance (2021) reiterates that the cornerstone of financial management is a well-planned budget. Budgeting involves tracking income, categorizing expenses, and setting saving goals. It offers a visual representation of where money goes, thereby providing an opportunity to identify and eliminate unnecessary expenses.
Creating a budget involves several steps (Kapoor et al., 2011):
- Identify income: Start by calculating the total income, including salaries, rental income, or dividends.
- Track expenses: Record daily expenses, including rent or mortgage payments, utilities, groceries, transportation, insurance, and personal care. Categorize them into ‘needs’ and ‘wants.’
- Set saving goals: Determine short-term and long-term financial goals, such as building an emergency fund, retirement savings, or funding education.
- Create a plan: Allocate income for each category – necessities, wants, and savings. A common principle is the 50/30/20 rule proposed by Elizabeth Warren, which recommends allocating 50% of income for needs, 30% for wants, and 20% for savings and debt repayment.
- Monitor and adjust: Regularly review the budget and adjust as necessary. It’s important to be flexible and realistic with budgeting to make it a sustainable practice.
Saving and Investing
As per Bodie, Treussard, and Willen’s paper (2009), saving and investing are two critical components of personal finance that cater to different financial goals. Saving provides a financial cushion for unexpected expenses, while investing is the route to grow wealth over time and outpace inflation.
Savings should be prioritized to create an emergency fund equivalent to 3-6 months of living expenses (Garman & Forgue, 2006). After setting up an emergency fund, savings should be directed towards short-term financial goals, such as buying a car or going on a vacation.
Investing, on the other hand, is aimed at achieving long-term financial goals. Investing in stocks, bonds, real estate, or mutual funds can help generate higher returns over the long term, albeit with varying degrees of risk (Fama & French, 1992). Therefore, individuals must assess their risk tolerance and financial goals before investing.
Another effective way to save money is by controlling spending. Garman and Forgue (2006) assert that this process involves distinguishing between needs and wants, prioritizing spending, and resisting impulse buying. By controlling spending, individuals can increase the amount of money saved, thereby providing more funds for investments and other financial goals.
Controlling spending can be achieved through various strategies, such as:
- Delay gratification: Resist the urge to make immediate purchases, especially for luxury or non-essential items. Practice waiting for 24-48 hours before making a significant purchase to ensure it is necessary and within budget (Ainslie, 1975).
- Use cash or debit cards: Studies show that people tend to spend less when using cash or debit cards compared to credit cards (Prelec & Simester, 2001). By using cash or a debit card, individuals can limit their spending to the money they already have.
- Shop with a list: A predetermined shopping list can help avoid unnecessary purchases and stay within the budget.
- Avoid lifestyle inflation: As income increases, it’s tempting to increase spending proportionally, a phenomenon known as lifestyle inflation. By avoiding this and maintaining a relatively consistent lifestyle, more money can be allocated to savings and investments (Kumra, 2017).
Behavioral Finance and Money-Saving
Behavioral finance studies the psychological factors affecting investment and financial decisions. In his book “Misbehaving: The Making of Behavioral Economics,” Richard Thaler (2015) presents key behavioral concepts that can significantly impact our saving behaviors:
- Mental Accounting: This refers to the tendency of people to categorize money into separate accounts based on subjective criteria, like the source of money and its intended use (Thaler, 1999). While it can lead to irrational financial decisions, mental accounting can also be leveraged to save money. For example, saving money in a separate ’emergency fund’ can help deter unnecessary spending.
- Loss Aversion: According to Tversky and Kahneman (1991), people tend to prefer avoiding losses to acquiring equivalent gains. By recognizing this tendency, individuals can manage their investments more prudently and resist panic-selling during market downturns.
- Endowment Effect: This is the phenomenon where people place a higher value on things merely because they own them (Kahneman et al., 1990). Understanding this bias can help individuals resist overspending on items they already own or don’t need.
Saving money is more than just a financial strategy; it’s a lifestyle choice. Effective personal finance management, which includes budgeting, saving, investing, and controlling spending, can lead to improved financial health and reduced stress. Understanding behavioral finance concepts can further enhance our money-saving behaviors. While the journey may seem challenging at first, persistence and discipline can make saving a habit and financial freedom an attainable goal.
- Ainslie, G. (1975). Specious reward: a behavioral theory of impulsiveness and impulse control. Psychological Bulletin, 82(4), 463.
- Bodie, Z., Treussard, J., & Willen, P. (2009). The theory of life-cycle saving and investing. The Journal of Economic Perspectives, 23(1), 45-66.
- Fama, E. F., & French, K. R. (1992). The Cross‐Section of Expected Stock Returns. the Journal of Finance, 47(2), 427-465.
- Garman, E. T., & Forgue, R. E. (2006). Personal Finance. Houghton Mifflin.
- Joo, S. (2008). Personal Financial Wellness. Handbook of Consumer Finance Research, 21-33.
- Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental Tests of the Endowment Effect and the Coase Theorem. Journal of Political Economy, 98(6), 1325-1348.
- Kapoor, J. R., Dlabay, L. R., & Hughes, R. J. (2011). Personal finance. McGraw-Hill/Irwin.
- Kumra, R. (2017). Understanding and Overcoming Lifestyle Inflation. Financial Planning Journal, 12(2), 43-50.
- Prelec, D., & Simester, D. (2001). Always leave home without it: A further investigation of the credit-card effect on willingness to pay. Marketing Letters, 12(1), 5-12.
- Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12(3), 183-206.
- Thaler, R. H. (2015). Misbehaving: The making of behavioral economics. WW Norton & Company.
- The Balance. (2021). How to Make a Budget in 6 Simple Steps. Retrieved from https://www.thebalance.com/how-to-make-a-budget-1289587
- Tversky, A., & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference-Dependent Model. The Quarterly Journal of Economics, 106(4), 1039-1061.
- Xiao, J. J., & Olson, G. I. (1993). Coordinating a Professional Financial Planning Service with a Personal Finance Class. Financial Counseling and Planning, 4, 127-145.