Budgeting Basics: How to Create a Budget and Stick to It thumbnail

Budgeting Basics: How to Create a Budget and Stick to It

Published May 16, 24
17 min read

Financial literacy is the ability to make effective and informed decisions regarding one's finances. The process is similar to learning the complex rules of a game. As athletes must master the fundamentals in their sport, people can benefit from learning essential financial concepts. This will help them manage their finances and build a solid financial future.

Default-Image-1722601883-1

In today's complex and changing financial landscape, it is more important than ever that individuals take responsibility for their own financial health. From managing student loans to planning for retirement, financial decisions can have long-lasting impacts. A study by FINRA's Investor Education Foundation showed a positive correlation between high levels of financial literacy and financial behaviors, such as saving for an emergency and planning retirement.

But it is important to know that financial education alone does not guarantee success. Critics claim that focusing exclusively on individual financial education ignores the systemic issues which contribute to financial disparity. Some researchers claim that financial education does not have much impact on changing behaviour. They point to behavioral biases as well as the complexity and variety of financial products.

Another perspective is that financial literacy education should be complemented by behavioral economics insights. This approach acknowledges that people do not always make rational decisions about money, even if they are well-informed. Some behavioral economics-based strategies have improved financial outcomes, including automatic enrollment in saving plans.

The key takeaway is that financial literacy, while important for managing personal finances and navigating the economy in general, is just a small part of it. Systemic factors, individual circumstances, and behavioral tendencies all play significant roles in financial outcomes.

Fundamentals of Finance

Basic Financial Concepts

The fundamentals of finance form the backbone of financial literacy. These include understanding:

  1. Income: The money received from work, investments or other sources.

  2. Expenses = Money spent on products and services.

  3. Assets are the things that you own and have value.

  4. Liabilities: Debts or financial commitments

  5. Net Worth: the difference between your assets (assets) and liabilities.

  6. Cash Flow: The total amount of money being transferred into and out of a business, especially as affecting liquidity.

  7. Compound Interest: Interest calculated using the initial principal plus the accumulated interest over the previous period.

Let's explore some of these ideas in more detail:

Income

The sources of income can be varied:

  • Earned income: Wages, salaries, bonuses

  • Investment income: Dividends, interest, capital gains

  • Passive income: Rental income, royalties, online businesses

Understanding the different income streams is important for tax and budget planning. For example, earned income is typically taxed at a higher rate than long-term capital gains in many tax systems.

Assets vs. Liabilities

Assets are things you own that have value or generate income. Examples include:

  • Real estate

  • Stocks and bonds

  • Savings accounts

  • Businesses

Liabilities, on the other hand, are financial obligations. They include:

  • Mortgages

  • Car loans

  • Credit card debt

  • Student Loans

The relationship between assets and liabilities is a key factor in assessing financial health. Some financial theories recommend acquiring assets which generate income or gain in value and minimizing liabilities. However, it's important to note that not all debt is necessarily bad - for instance, a mortgage could be considered an investment in an asset (real estate) that may appreciate over time.

Compound Interest

Compounding interest is the concept where you earn interest by earning interest. Over time, this leads to exponential growth. This concept works both for and against individuals - it can help investments grow, but also cause debts to increase rapidly if not managed properly.

For example, consider an investment of $1,000 at a 7% annual return:

  • After 10 years, it would grow to $1,967

  • In 20 years it would have grown to $3,870

  • In 30 years it would have grown to $7.612

This demonstrates the potential long-term impact of compound interest. However, it's crucial to remember that these are hypothetical examples and actual investment returns can vary significantly and may include periods of loss.

Knowing these basic concepts can help individuals create a better picture of their financial status, just as knowing the score helps you plan your next move.

Financial Planning and Goal Setting

Financial planning involves setting financial goals and creating strategies to work towards them. It's similar to an athlete's regiment, which outlines steps to reach maximum performance.

A financial plan includes the following elements:

  1. Set SMART financial goals (Specific Measurable Achievable Relevant Time-bound Financial Goals)

  2. Creating a budget that is comprehensive

  3. Develop strategies for saving and investing

  4. Review and adjust the plan regularly

Setting SMART Financial Goals

In finance and other fields, SMART acronym is used to guide goal-setting.

  • Specific: Clear and well-defined goals are easier to work towards. For example, saving money is vague. However, "Save $10,000", is specific.

  • You should have the ability to measure your progress. In this case, you can measure how much you've saved towards your $10,000 goal.

  • Achievable: Your goals must be realistic.

  • Relevance: Goals should reflect your life's objectives and values.

  • Set a deadline to help you stay motivated and focused. For example: "Save $10,000 over 2 years."

Creating a Comprehensive Budget

A budget is an organized financial plan for tracking income and expenditures. Here's a quick overview of budgeting:

  1. Track all income sources

  2. List all expenses, categorizing them as fixed (e.g., rent) or variable (e.g., entertainment)

  3. Compare income with expenses

  4. Analyze results and make adjustments

The 50/30/20 rule is a popular guideline for budgeting. It suggests that you allocate:

  • Use 50% of your income for basic necessities (housing food utilities)

  • Spend 30% on Entertainment, Dining Out

  • 20% for savings and debt repayment

This is only one way to do it, as individual circumstances will vary. Such rules may not be feasible for some people, particularly those on low incomes with high living expenses.

Savings and Investment Concepts

Saving and investing are key components of many financial plans. Listed below are some related concepts.

  1. Emergency Fund: This is a fund that you can use to save for unplanned expenses or income interruptions.

  2. Retirement Savings (Renunciation): Long-term investments for post-work lives, which may involve specific account types.

  3. Short-term savings: For goals in the next 1-5 year, usually kept in easily accessible accounts.

  4. Long-term Investments (LTI): For goals beyond 5 years, which often involve a diversified portfolio.

There are many opinions on the best way to invest for retirement or emergencies. These decisions are dependent on personal circumstances, level of risk tolerance, financial goals and other factors.

You can think of financial planning as a map for a journey. The process involves understanding where you are starting from (your current financial situation), your destination (financial goal), and possible routes (financial plans) to reach there.

Risk Management Diversification

Understanding Financial Risques

Risk management in finance involves identifying potential threats to one's financial health and implementing strategies to mitigate these risks. This concept is similar to how athletes train to avoid injuries and ensure peak performance.

Key components of Financial Risk Management include:

  1. Potential risks can be identified

  2. Assessing risk tolerance

  3. Implementing risk mitigation strategies

  4. Diversifying investment

Identification of Potential Risks

Financial risks come from many different sources.

  • Market risk: The potential for losing money because of factors which affect the performance of the financial marketplaces.

  • Credit risk: The risk of loss resulting from a borrower's failure to repay a loan or meet contractual obligations.

  • Inflation: the risk that money's purchasing power will decline over time as a result of inflation.

  • Liquidity Risk: The risk that you will not be able to sell your investment quickly at a fair value.

  • Personal risk is a term used to describe risks specific to an individual. For example, job loss and health issues.

Assessing Risk Tolerance

The risk tolerance of an individual is their ability and willingness endure fluctuations in investment value. This is influenced by:

  • Age: Younger persons have a larger time frame to recover.

  • Financial goals: Short-term goals usually require a more conservative approach.

  • Stable income: A steady income may allow you to take more risks with your investments.

  • Personal comfort: Some people have a natural tendency to be more risk-averse.

Risk Mitigation Strategies

Common strategies for risk reduction include:

  1. Insurance: A way to protect yourself from major financial losses. Includes health insurance as well as life insurance, property and disability coverage.

  2. Emergency Fund: Provides a financial cushion for unexpected expenses or income loss.

  3. Debt Management: By managing debt, you can reduce your financial vulnerability.

  4. Continuous Learning: Staying informed about financial matters can help in making more informed decisions.

Diversification: A Key Risk Management Strategy

Diversification, or "not putting your eggs all in one basket," is a common risk management strategy. By spreading your investments across different industries, asset classes, and geographic areas, you can potentially reduce the impact if one investment fails.

Consider diversification similar to a team's defensive strategies. The team uses multiple players to form a strong defense, not just one. A diversified portfolio of investments uses different types of investment to protect against potential financial losses.

Diversification: Types

  1. Asset Class diversification: Diversifying investments between stocks, bonds, real-estate, and other asset categories.

  2. Sector Diversification Investing in a variety of sectors within the economy.

  3. Geographic Diversification - Investing in various countries or areas.

  4. Time Diversification is investing regularly over a period of time as opposed to all at once.

Although diversification is an accepted financial principle, it doesn't protect you from loss. All investments carry some level of risk, and it's possible for multiple asset classes to decline simultaneously, as seen during major economic crises.

Some critics say that it is hard to achieve true diversification due to the interconnectedness of global economies, especially for individuals. They suggest that during times of market stress, correlations between different assets can increase, reducing the benefits of diversification.

Diversification is still a key principle of portfolio theory, and it's widely accepted as a way to manage risk in investments.

Investment Strategies and Asset Allocution

Investment strategies are plans designed to guide decisions about allocating assets in various financial instruments. These strategies can also be compared with an athlete's carefully planned training regime, which is tailored to maximize performance.

Key aspects of investment strategies include:

  1. Asset allocation: Dividing investment among different asset classes

  2. Portfolio diversification: Spreading investments within asset categories

  3. Regular monitoring and rebalancing : Adjusting the Portfolio over time

Asset Allocation

Asset allocation involves dividing investments among different asset categories. The three main asset classes include:

  1. Stocks (Equities:) Represent ownership of a company. Generally considered to offer higher potential returns but with higher risk.

  2. Bonds: They are loans from governments to companies. Generally considered to offer lower returns but with lower risk.

  3. Cash and Cash-Equivalents: This includes short-term government bond, savings accounts, money market fund, and other cash equivalents. These investments have the lowest rates of return but offer the highest level of security.

Some factors that may influence your decision include:

  • Risk tolerance

  • Investment timeline

  • Financial goals

You should be aware that asset allocation does not have a universal solution. There are some general rules (such as subtracting 100 or 110 from your age to determine what percentage of your portfolio could be stocks) but these are only generalizations that may not work for everyone.

Portfolio Diversification

Diversification can be done within each asset class.

  • For stocks: This can include investing in companies that are different sizes (smallcap, midcap, largecap), sectors, or geographic regions.

  • For bonds, this could involve changing the issuers' (government or corporate), their credit quality and their maturities.

  • Alternative investments: Some investors consider adding real estate, commodities, or other alternative investments for additional diversification.

Investment Vehicles

There are many ways to invest in these asset categories:

  1. Individual Stocks and Bonds: Offer direct ownership but require more research and management.

  2. Mutual Funds are professionally managed portfolios that include stocks, bonds or other securities.

  3. Exchange-Traded Funds. Similar to mutual fund but traded as stocks.

  4. Index Funds are mutual funds or ETFs that track a particular market index.

  5. Real Estate Investment Trusts (REITs): Allow investment in real estate without directly owning property.

Passive vs. Active Investment Passive Investing

There is a debate going on in the investing world about whether to invest actively or passively:

  • Active investing: Investing that involves trying to beat the market by selecting individual stocks or timing market movements. It usually requires more knowledge and time.

  • Passive Investing involves purchasing and holding an diversified portfolio. This is often done through index funds. It is based upon the notion that it can be difficult to consistently exceed the market.

This debate is still ongoing with supporters on both sides. Proponents of active investment argue that skilled managers have the ability to outperform markets. However, proponents passive investing point out studies showing that most actively managed funds perform below their benchmark indexes over the longer term.

Regular Monitoring and Rebalancing

Over time, certain investments may perform better. This can cause a portfolio's allocation to drift away from the target. Rebalancing is the process of periodically adjusting a portfolio to maintain its desired asset allocation.

Rebalancing is the process of adjusting the portfolio to its target allocation. If, for example, the goal allocation was 60% stocks and 40% bond, but the portfolio had shifted from 60% to 70% after a successful year in the stock markets, then rebalancing will involve buying some bonds and selling others to get back to the target.

Rebalancing is not always done annually. Some people rebalance only when allocations are above a certain level.

Think of asset allocating as a well-balanced diet for an athlete. As athletes require a combination of carbohydrates, proteins and fats to perform optimally, an investment portfolio includes a variety of assets that work together towards financial goals, while managing risk.

Keep in mind that all investments carry risk, which includes the possibility of losing principal. Past performance is not a guarantee of future results.

Long-term retirement planning

Long-term financial plans include strategies that will ensure financial security for the rest of your life. This includes estate and retirement planning, similar to an athlete’s career long-term plan. The goal is to be financially stable, even after their sports career has ended.

The following are the key components of a long-term plan:

  1. Understanding retirement options: Understanding the different types of accounts, setting goals and estimating future costs.

  2. Estate planning - preparing assets to be transferred after death. Includes wills, estate trusts, tax considerations

  3. Consider future healthcare costs and needs.

Retirement Planning

Retirement planning involves estimating how much money might be needed in retirement and understanding various ways to save for retirement. Here are some important aspects:

  1. Estimating Retirement Needs: Some financial theories suggest that retirees might need 70-80% of their pre-retirement income to maintain their standard of living in retirement. This is only a generalization, and individual needs may vary.

  2. Retirement Accounts

    • Employer sponsored retirement accounts. Often include employer matching contributions.

    • Individual Retirement Accounts: These can be Traditional (possibly tax-deductible contributions and taxed withdrawals), or Roth (after tax contributions, potential tax-free withdrawals).

    • Self-employed individuals have several retirement options, including SEP IRAs or Solo 401(k).

  3. Social Security: A program of the government that provides benefits for retirement. It's crucial to understand the way it works, and the variables that can affect benefits.

  4. The 4% Rules: A guideline stating that retirees may withdraw 4% their portfolio in their first retirement year and adjust that amount to inflation each year. There is a high likelihood that they will not outlive the money. [...previous content remains the same...]

  5. The 4% Rule: A guideline suggesting that retirees could withdraw 4% of their portfolio in the first year of retirement, then adjust that amount for inflation each year, with a high probability of not outliving their money. The 4% rule has caused some debate, with financial experts claiming it is either too conservative or excessively aggressive depending on the individual's circumstances and the market.

Important to remember that retirement is a topic with many variables. Factors such as inflation, market performance, healthcare costs, and longevity can all significantly impact retirement outcomes.

Estate Planning

Estate planning consists of preparing the assets to be transferred after death. Some of the main components include:

  1. Will: A legal document which specifies how the assets of an individual will be distributed upon their death.

  2. Trusts: Legal entity that can hold property. Trusts come in many different types, with different benefits and purposes.

  3. Power of Attorney: Appoints a person to make financial decisions in an individual's behalf if that individual is unable.

  4. Healthcare Directive: This document specifies an individual's wishes regarding medical care in the event of their incapacitating condition.

Estate planning can be complicated, as it involves tax laws, personal wishes, and family dynamics. Estate laws can differ significantly from country to country, or even state to state.

Healthcare Planning

Planning for future healthcare is an important part of financial planning, as healthcare costs continue to increase in many countries.

  1. Health Savings Accounts (HSAs): In some countries, these accounts offer tax advantages for healthcare expenses. Rules and eligibility may vary.

  2. Long-term Care Insurance: Policies designed to cover the costs of extended care in a nursing home or at home. These policies are available at a wide range of prices.

  3. Medicare: Medicare is the United States' government health care insurance program for those 65 years of age and older. Understanding Medicare coverage and its limitations is a crucial part of retirement for many Americans.

It's worth noting that healthcare systems and costs vary significantly around the world, so healthcare planning needs can differ greatly depending on an individual's location and circumstances.

This page was last edited on 29 September 2017, at 19:09.

Financial literacy is a complex and vast field that includes a variety of concepts, from basic budgeting up to complex investment strategies. Financial literacy is a complex field that includes many different concepts.

  1. Understanding basic financial concepts

  2. Developing financial skills and goal-setting abilities

  3. Managing financial risks through strategies like diversification

  4. Understanding asset allocation, investment strategies and their concepts

  5. Plan for your long-term financial goals, including retirement planning and estate planning

Although these concepts can provide a solid foundation for financial education, it is important to remember that the financial industry is always evolving. Changes in financial regulations, new financial products and the global economy all have an impact on personal financial management.

Achieving financial success isn't just about financial literacy. Financial outcomes are influenced by systemic factors as well as individual circumstances and behavioral tendencies. Some critics of financial literacy point out that the education does not address systemic injustices and can place too much blame on individuals.

Another perspective highlights the importance of combining behavioral economics insights with financial education. This approach acknowledges the fact that people may not make rational financial decisions even when they are well-informed. Strategies that account for human behavior and decision-making processes may be more effective in improving financial outcomes.

It's also crucial to acknowledge that there's rarely a one-size-fits-all approach to personal finance. What may work for one person, but not for another, is due to the differences in income and goals, as well as risk tolerance.

Personal finance is complex and constantly changing. Therefore, it's important to stay up-to-date. It could include:

  • Staying up to date with economic news is important.

  • Update and review financial plans on a regular basis

  • Find reputable financial sources

  • Consider seeking professional financial advice when you are in a complex financial situation

Financial literacy is a valuable tool but it is only one part of managing your personal finances. Critical thinking, adaptability, and a willingness to continually learn and adjust strategies are all valuable skills in navigating the financial landscape.

Financial literacy is about more than just accumulating wealth. It's also about using financial skills and knowledge to reach personal goals. Financial literacy can mean many things to different individuals - achieving financial stability, funding life goals, or being able give back to the community.

By developing a strong foundation in financial literacy, individuals can be better equipped to navigate the complex financial decisions they face throughout their lives. But it is important to always consider your unique situation and seek out professional advice when you need to, especially when making major financial choices.


The information provided in this article is for general informational and educational purposes only. It is not intended as financial advice, nor should it be construed or relied upon as such. The author and publishers of this content are not licensed financial advisors and do not provide personalized financial advice or recommendations. The concepts discussed may not be suitable for everyone, and the information provided does not take into account individual circumstances, financial situations, or needs. Before making any financial decisions, readers should conduct their own research and consult with a qualified financial advisor. The author and publishers shall not be liable for any errors, inaccuracies, omissions, or any actions taken in reliance on this information.