How to Budget Effectively

Budgeting effectively is not easy. For many people, budgeting means spending only what they can afford to until next month’s pay check. While this may mean that all of the bills are paid, mortgage repayments are met and an overdraft is avoided, the reality is that living from month-to-month is not an optimal way of budgeting in the long run.

Retirement

A key reason for this is retirement. It is something that all of us will hopefully experience at some point in life. Therefore, it must be planned for. Certainly, the government may provide some assistance later in life, but for many people the reality is that a proportion of earnings must be saved each month to be spent at a (much) later date.

Clearly, the more that is saved, the sooner retirement will come. In this sense, saving as much as you can is the most obvious advice. However, for many people, the temptation to spend everything in an easy access account each month is too great. That’s where monthly pension contributions can really help. Syphoning off an amount each month to your pension before it even reaches your easy access account could be a sensible first step on the road to effective budgeting.

Spending versus saving

According to many financial advisers, saving an amount between 10% and 15% of earnings each month is a sensible starting point. Crucially, it should enable you to make all bill payments while having some left over for discretionary items such as holidays and socialising.

Although 10% to 15% may not sound all that much, over a long period of time it could prove to be a significant amount of money. That’s because global stock markets generally offer an annual return of around 7% over the long run. Capital invested today will therefore grow by 21 times over a 45 year working life. This should help with a retirement fund, but could also offer at least some passive income to help with bills and to pay for discretionary items.

Passive income

Of course, the bulk of most people’s income is derived from their full-time employment. However, the appeal of passive income is perhaps underestimated. For example, assuming an annual return of 7% from investing in shares, every 15% of your earnings which are invested in the stock market could boost your overall income by over 1% per annum.

This may not sound all that much. However, that 1% of additional return will be compounded so that over a number of years it will really add up. Furthermore, over a multi-year period, the return from your passive income will be boosted by additional contributions made to your portfolio each year. This could eventually mean that your reliance on full-time work diminishes in favour of a greater dependence on passive income.

Looking ahead

While budgeting in its simplest form focuses on balancing income and expenditure, the reality is that the saving and investing component of budgeting is the most important. It may not be a life changer in the short run, but by developing a passive income over a sustained period, your financial outlook is likely to improve dramatically.