Indulgent spending can lead to difficulties when financing mandatory expenses in the future. Before spending, bear in mind your income, and unavoidable monthly expenses.
uma Shashikant ET 16 June 2014
Wealth building does not start if there are no consistent savings. Unless there is some balance in the bank, before the next salary comes in, we are not generating a surplus, and we will not be able to contribute towards our future financial well-being. Income tends to trigger expenses, not savings. But, without a handle on how we spend, we may not be able to move forward on financial planning.
How and why we spend is quite a complex subject. Psychologists have studied the power of persuasion, so amplified by advertisements and promotions that create needs where none existed. Brands have been built to sell products and services at premium prices that cater to the psychological needs of shoppers to feel important, socially accepted, privileged and exclusive. In the film Confessions of a Shopaholic, the protagonist, Rebecca, turns to shopping to deal with a range of emotional downturns — loss of a job, friend or lover conundrum. Retail therapy is a known remedy to get serotonin and oxytocin levels up.
Modern cognitive psychologists have used advanced technologies to map the brain. Antonio Rangel, professor of behavioural biology and neuroscience, Caltech, has conducted experiments that scan the brain when it makes money-related decisions. The ventral medial prefrontal cortex is activated when we judge a product on its immediate value to us. A rising stock, an appetising meal, or an expensive gadget appeals to this part of our brain, which is activated when we make impulsive decisions. Another part of the brain — the dorsolateral prefrontal cortex (DLPFC) — deals with more abstract long-term consequences.
An active DLPFC would prompt us to check the stocks' fundamentals, remind us of the health consequences of a high-calorie meal, and warn us about the dent the gadget would cause to our retirement savings. The DLPFC is not always active; not for most spenders who seek instant gratification, or are looking for an immediate psychological high. It needs effort.
What can we do about our spending habits to bring some control into our lives? It is quite old-fashioned to make a budget. Many do not even care to know how much of their income goes towards essential spending that is unavoidable. The first step is to have a sense of the mandatory spending that we anyway incur, month after month. This tells us how much room we actually have to get impulsive with spending. A mental limit on what is available for indulgence can be set only if we know how much is not available to spend — we have to pay rent, grocery bills, fee and staff salaries, etc. If the mandatory spend is less then 50% of our incomes, we have the breathing space to spend without too much stress. The higher the mandatory spend, the greater the need to be careful about what we buy and why.
The second step is a financial strategy review of our spending on durables. A company that buys an asset evaluates how long the asset will be used and accordingly depreciates it. Since a household also buys durables for comfort and for enhancing its productivity, they can be similarly evaluated. A television bought forRs 1.2 lakh and replaced every two years, translates to spendings of Rs 5,000 a month. Keeping in mind its income, the family has to evaluate if it is affordable and worthwhile. The decision to upgrade the television should happen in this context. This would apply to all durables. If a Rs 6 lakh car is bought and used for four years and it has an estimated resale value of Rs 1 lakh, the household is allocating Rs 10,000 a month to it.
The third step is to measure expensesusing a percentage approach to provide a mental budget. If we assign 10% of our annual income to holidaying, the micro decisions about where to go, how to travel and where to stay are better managed within the context of how much has been allocated. A family that routinely eats out and finds that the smaller restaurant bills add up to a large expense, can bring in control if they decide what percentage of the income should go towards this indulgence. It is then easy to juggle an expensive brunch with a drive out to the eatery on the highway, when the limit for the expense is close to being breached. From birthday party to anniversary gifts, all spends can be assigned a share of the household's income. This approach enables roping in all members of the family, building consensus on what is available, and learning to make choices within agreed overall limits. It is likely to turn out to be a valuable exercise in teaching children about finance; after all, making choices within a given limit is a fundamental financial skill that needs to be acquired.
The fourth step is to see how we are funding our expenses. If most of our funding is from borrowings, the expenses are a charge on the future income. The discretionary and indulgent expenses of the present are then converting into mandatory and compulsory expenses of the future. That will leave behind even smaller amounts for other future expenses. This opens up the risk of credit card overuse, leading to a higher debt burden.
Households that find themselves in a debt trap are typically those that have incurred high big-ticket expenses on credit that curtail the ability to spend even on essentials on an on-going basis. Not all debt is bad, but debt that takes away more than 40% of the income leaves too little room for financial manoeuvring.
When financial planners ask households to shun debt, they warn about the possibility of debt building up beyond the ability to repay and leading to cash and solvency crises.
Spending tends to be mentally associated with fun, joy and power. It is easy to overdo it when the pleasure of swiping the credit card is isolated from the pain of paying the bills. Budgeting and savings are associated with boredom and routine. That is why they do not receive the attention they need. Long-term wealth, just as virtue and character, is built only when tougher choices are made over easier ones that bring instant gratification.
(The author is Managing Director, Centre for Investment Education and Learning.)
Wealth building does not start if there are no consistent savings. Unless there is some balance in the bank, before the next salary comes in, we are not generating a surplus, and we will not be able to contribute towards our future financial well-being. Income tends to trigger expenses, not savings. But, without a handle on how we spend, we may not be able to move forward on financial planning.
How and why we spend is quite a complex subject. Psychologists have studied the power of persuasion, so amplified by advertisements and promotions that create needs where none existed. Brands have been built to sell products and services at premium prices that cater to the psychological needs of shoppers to feel important, socially accepted, privileged and exclusive. In the film Confessions of a Shopaholic, the protagonist, Rebecca, turns to shopping to deal with a range of emotional downturns — loss of a job, friend or lover conundrum. Retail therapy is a known remedy to get serotonin and oxytocin levels up.
Modern cognitive psychologists have used advanced technologies to map the brain. Antonio Rangel, professor of behavioural biology and neuroscience, Caltech, has conducted experiments that scan the brain when it makes money-related decisions. The ventral medial prefrontal cortex is activated when we judge a product on its immediate value to us. A rising stock, an appetising meal, or an expensive gadget appeals to this part of our brain, which is activated when we make impulsive decisions. Another part of the brain — the dorsolateral prefrontal cortex (DLPFC) — deals with more abstract long-term consequences.
An active DLPFC would prompt us to check the stocks' fundamentals, remind us of the health consequences of a high-calorie meal, and warn us about the dent the gadget would cause to our retirement savings. The DLPFC is not always active; not for most spenders who seek instant gratification, or are looking for an immediate psychological high. It needs effort.
What can we do about our spending habits to bring some control into our lives? It is quite old-fashioned to make a budget. Many do not even care to know how much of their income goes towards essential spending that is unavoidable. The first step is to have a sense of the mandatory spending that we anyway incur, month after month. This tells us how much room we actually have to get impulsive with spending. A mental limit on what is available for indulgence can be set only if we know how much is not available to spend — we have to pay rent, grocery bills, fee and staff salaries, etc. If the mandatory spend is less then 50% of our incomes, we have the breathing space to spend without too much stress. The higher the mandatory spend, the greater the need to be careful about what we buy and why.
The second step is a financial strategy review of our spending on durables. A company that buys an asset evaluates how long the asset will be used and accordingly depreciates it. Since a household also buys durables for comfort and for enhancing its productivity, they can be similarly evaluated. A television bought forRs 1.2 lakh and replaced every two years, translates to spendings of Rs 5,000 a month. Keeping in mind its income, the family has to evaluate if it is affordable and worthwhile. The decision to upgrade the television should happen in this context. This would apply to all durables. If a Rs 6 lakh car is bought and used for four years and it has an estimated resale value of Rs 1 lakh, the household is allocating Rs 10,000 a month to it.
How and why we spend is quite a complex subject. Psychologists have studied the power of persuasion, so amplified by advertisements and promotions that create needs where none existed. Brands have been built to sell products and services at premium prices that cater to the psychological needs of shoppers to feel important, socially accepted, privileged and exclusive. In the film Confessions of a Shopaholic, the protagonist, Rebecca, turns to shopping to deal with a range of emotional downturns — loss of a job, friend or lover conundrum. Retail therapy is a known remedy to get serotonin and oxytocin levels up.
Modern cognitive psychologists have used advanced technologies to map the brain. Antonio Rangel, professor of behavioural biology and neuroscience, Caltech, has conducted experiments that scan the brain when it makes money-related decisions. The ventral medial prefrontal cortex is activated when we judge a product on its immediate value to us. A rising stock, an appetising meal, or an expensive gadget appeals to this part of our brain, which is activated when we make impulsive decisions. Another part of the brain — the dorsolateral prefrontal cortex (DLPFC) — deals with more abstract long-term consequences.
An active DLPFC would prompt us to check the stocks' fundamentals, remind us of the health consequences of a high-calorie meal, and warn us about the dent the gadget would cause to our retirement savings. The DLPFC is not always active; not for most spenders who seek instant gratification, or are looking for an immediate psychological high. It needs effort.
What can we do about our spending habits to bring some control into our lives? It is quite old-fashioned to make a budget. Many do not even care to know how much of their income goes towards essential spending that is unavoidable. The first step is to have a sense of the mandatory spending that we anyway incur, month after month. This tells us how much room we actually have to get impulsive with spending. A mental limit on what is available for indulgence can be set only if we know how much is not available to spend — we have to pay rent, grocery bills, fee and staff salaries, etc. If the mandatory spend is less then 50% of our incomes, we have the breathing space to spend without too much stress. The higher the mandatory spend, the greater the need to be careful about what we buy and why.
The second step is a financial strategy review of our spending on durables. A company that buys an asset evaluates how long the asset will be used and accordingly depreciates it. Since a household also buys durables for comfort and for enhancing its productivity, they can be similarly evaluated. A television bought forRs 1.2 lakh and replaced every two years, translates to spendings of Rs 5,000 a month. Keeping in mind its income, the family has to evaluate if it is affordable and worthwhile. The decision to upgrade the television should happen in this context. This would apply to all durables. If a Rs 6 lakh car is bought and used for four years and it has an estimated resale value of Rs 1 lakh, the household is allocating Rs 10,000 a month to it.
The third step is to measure expensesusing a percentage approach to provide a mental budget. If we assign 10% of our annual income to holidaying, the micro decisions about where to go, how to travel and where to stay are better managed within the context of how much has been allocated. A family that routinely eats out and finds that the smaller restaurant bills add up to a large expense, can bring in control if they decide what percentage of the income should go towards this indulgence. It is then easy to juggle an expensive brunch with a drive out to the eatery on the highway, when the limit for the expense is close to being breached. From birthday party to anniversary gifts, all spends can be assigned a share of the household's income. This approach enables roping in all members of the family, building consensus on what is available, and learning to make choices within agreed overall limits. It is likely to turn out to be a valuable exercise in teaching children about finance; after all, making choices within a given limit is a fundamental financial skill that needs to be acquired.
The fourth step is to see how we are funding our expenses. If most of our funding is from borrowings, the expenses are a charge on the future income. The discretionary and indulgent expenses of the present are then converting into mandatory and compulsory expenses of the future. That will leave behind even smaller amounts for other future expenses. This opens up the risk of credit card overuse, leading to a higher debt burden.
Households that find themselves in a debt trap are typically those that have incurred high big-ticket expenses on credit that curtail the ability to spend even on essentials on an on-going basis. Not all debt is bad, but debt that takes away more than 40% of the income leaves too little room for financial manoeuvring.
When financial planners ask households to shun debt, they warn about the possibility of debt building up beyond the ability to repay and leading to cash and solvency crises.
Spending tends to be mentally associated with fun, joy and power. It is easy to overdo it when the pleasure of swiping the credit card is isolated from the pain of paying the bills. Budgeting and savings are associated with boredom and routine. That is why they do not receive the attention they need. Long-term wealth, just as virtue and character, is built only when tougher choices are made over easier ones that bring instant gratification.
(The author is Managing Director, Centre for Investment Education and Learning.)
The fourth step is to see how we are funding our expenses. If most of our funding is from borrowings, the expenses are a charge on the future income. The discretionary and indulgent expenses of the present are then converting into mandatory and compulsory expenses of the future. That will leave behind even smaller amounts for other future expenses. This opens up the risk of credit card overuse, leading to a higher debt burden.
Households that find themselves in a debt trap are typically those that have incurred high big-ticket expenses on credit that curtail the ability to spend even on essentials on an on-going basis. Not all debt is bad, but debt that takes away more than 40% of the income leaves too little room for financial manoeuvring.
When financial planners ask households to shun debt, they warn about the possibility of debt building up beyond the ability to repay and leading to cash and solvency crises.
Spending tends to be mentally associated with fun, joy and power. It is easy to overdo it when the pleasure of swiping the credit card is isolated from the pain of paying the bills. Budgeting and savings are associated with boredom and routine. That is why they do not receive the attention they need. Long-term wealth, just as virtue and character, is built only when tougher choices are made over easier ones that bring instant gratification.
(The author is Managing Director, Centre for Investment Education and Learning.)
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