Are you someone who is one paycheck, one customer, or one gig from broke?
Then this guide is not for you.
Do you have more serious issues than thinking about saving for your future.
The rest of you, who religiously obey the 101 rule of personal finance – The mighty positive cash flow each month rule, then this article will help you to maximize your savings potential.
This article is part of my goal to earn $100 of side income each month on average.
The reason I wrote this guide is to document the thinking process of someone, who never saved any money in his life by using available insured financial products.
That someone is me.
All my productive life I kept my free hard earned cash laying on the current account.
Gaining a whopping 0.02% annually on interest rate while at the same time gradually losing percent of my deposit annually thanks to inflation and banking fees.
Now it’s time to take control and start to manage my money properly…as a company.
First, let’s start with the basics.
The 101 rule of personal finance
What is 101 rule of personal finance you ask?
Positive Cash Flow = Monthly Income – Monthly Expenses > 0
Let’s illustrate this formula on Jane Doe, up and coming superstar blogger for the local newspaper in New Johnsonville, Nebraska.
Assume her monthly take-home paycheck is $1000 and this month she spends $500 on rent, $400 on food and $200 on a new pair of Michael Kors designer shoes.
A total of $1100 in expenses.
In order to fund her new shoes, she has to use her platinum credit card and therefore ends in debt.
Her cash flow is now negative by $100.
Next month she reads my article on how to max her potential and decides to take charge of her life and change things she can control in order to be her best self.
Jane immediately identifies two action steps to improve her personal finance management.
1. Her income.
She creates an account on Fiverr and starts offering copywriting services.
With a little effort, she can make $200 of side income each month.
3. Her spending habits.
She won’t buy any new clothes unless her cash flow allows to.
Additionally, she changed her mindset and is now averse to her past consumer lifestyle formed by media and the most evil tv show of all time “The sex and the City”.
A month goes by and she is able to repay her debt and her cash flow is for the first time positive!
$1000 pay-check + $200 side income – $500 rent – 400$ food – $100 debt = $200
With $200 she can do wonders.
She can buy that new hot Louis Vuitton designer pillow for $200 she saw while window-shopping.
Or she can put all of it into a savings account.
She is a smart girl and decides to save.
But wait. Is saving all-cash a good idea?
What if she accidentally drops her phone into a toilet while tindering and needs hot cash to buy a new one?
What if her bank goes bankrupt tomorrow and she has to wait months to access her savings?
Okay, that might not be probable, but when you want to maximize something, it’s always a compromise between benefits and risks.
Confused about how much she should save each month and how much to keep in cash she turns to her former schoolmate Matt, who is now an award-winning certified personal finance advisor at the local branch of New Johnsonville Imperial Bank of Agriculture.
Matt loaded with general knowledge from a top-class MBA at the State University of Johnsonville fires up with wisdom you most probably heard before.
“The 50/30/20 Rule of Thumb for Budgeting”
“To save X by Y years you should put aside Z into saving account and invest rest into index funds. Capital markets will take care of your retirement savings, I promise”
I call that BS.
Let’s bust each rule one by one.
- Spend no more than 50% of your after-tax income on necessities.
- Spend no more than 30% of your total money on things you want.
- Put 20% of your after-tax income into repaying debt or savings account.
Okay, looks like this rule won’t work for Jane.
First. 50% of after-tax income is not enough to cover her living expenses. $900 represents 75% of her monthly income and 75% is more than 50% required by the rule. Make sense.
Second. 30% of total wealth rule is too strict as she has only $200 of spare cash from her last pay-check. According to the rule, she can spend only $60 on the things she wants. 30% of $200 is $60.
On paper, the rule sounds reasonable. But what if she wants to buy a camera for $200 because she discovered her passion for photography ???? and wants to sell photos online?
Jane would have to wait 3 months before she has enough cash to comply with this rule.
3 months of wasted time while she could work on a new passive income stream.
Third. 20% of saving is also a sound principle. But it’s not flexible. See the example above.
She would put 20% of her income or $240 into a savings account, which leaves her with only $60 of working capital.
Goal-based saving rule
Another rule that sucks.
All budgeting apps are flooded with this rule like a plague.
Let’s say Jane wants to save for the boob job she was always dreaming about.
The official catalog price for breast implants in New Johnsonville General Hospital is $5000.
Additionally, she also wants a nose job, because, well, the nose was the reason she failed at modeling career 3 years ago.
The price for Rhinoplasty is a little steeper and starts at $7000.
According to the rule, she now has two budgets to track. Each allocates free cash by 50:50.
If $200 goes to saving accounts, then $100 goes directly into a retirement fund.
End the end it would take her 60 months or 5 years to collect enough funds to upgrade herself.
By that time, Jane probably won’t need to pay for plastic surgery anymore, because she will meet Mr. Right along the way.
Without a doubt, he will happily pay for her upgrades to prolong the longevity of her attractiveness.
See. It’s pointless to live in denial for such a long time. If it takes years to get it, the solution is not to wait it out, but to speed up the saving process, to increase income.
Also, there is always a risk, that the thing you wanted years ago does not have the same value in the present.
I thought 6 years ago, that it would be super cool to save for second hand BMW 3 in M-Paket edition. Today I still see it as a nice car, but I don’t value buying it anymore.
The next fallacy is to trust financial advisors with your retirement money and rely purely on capital markets and pension funds.
First, they charge you an abnormal amount of fees for almost no added value.
Second, you are not in control of markets, government, or central banks.
They control you.
With a glimpse of a second, the next economic crisis comes and your portfolio value is cut by half.
Or worse the government decides to devalue the national currency and suddenly bread costs twice as much.
Long story short never ever let anyone manage your savings. It’s always better to do it yourself.
So is there a better way to manage your cash? Gimme solution already!
Let me introduce you 2 ultimate data-driven scientific methods for cash management, that will help you maximize…
A) Liquidity a.k.a. keeping just enough cash so you don’t spend much on transaction costs.
B) Interest earned from holding cash in a savings account.
Baumol’s Economic Order Quantity Model of Cash Management
Some dude called William J. Baumol came up with an idea, that managing cash is similar to managing inventory in a large corporation.
Inspired by the corporate finance way of managing working capital, he proposed a formula, that calculates the optimal cash balance.
The so-called optimum point is a tradeoff between the opportunity cost of holding cash (the interest you would earn holding cash in a savings account) and the transaction cost of withdrawing cash from a savings account (interest foregone, the fee for cash withdrawal).
Baumol’s Models has a few limiting assumptions:
– You know yourself and you can control your spending habits.
– You know with exact precision your living expenses or can predict how much you need to spend.
– The opportunity cost of holding cash is known and remains constant.
– The transaction cost of withdrawing cash from a saving account is known and remains constant
Then Baumol’s formula is defined as:
C = Optimum balance
T = Annual or monthly cash spending
F = Fixed cost per transaction (interest foregone, withdrawal fee)
i = Opportunity cost of holding cash (interest foregone)
The key problem formula solves is how to optimally obtain the necessary cash at the lowest cost and at the same time earn maximum interest, that the bank pays.
Fewer withdrawals equal lower costs, while the larger the withdrawal the higher the opportunity cost (i.e., interest foregone)
How can Jane utilize this budgeting framework? Let’s see.
A = $900 living expenses
F = $2 per transaction
i = 1% annual interest rate
C = ((2*900*2/(0.01/12))^(1/2) = ((3600)/(0.01/12))^(1/2) = $2079
In other words.
Jane should always keep $2079 in her purse or current account with a zero interest rate. Because transaction costs are so high, making frequent saving every month and then withdrawing big portion to cover living expenses unfeasible.
By following Baumol’s model, Jane has always enough emergency cash available and can survive 2.4 months without a functioning banking system.
Depositing into saving account will make sense after she collects more than $2079 in cash, which is after 7th her pay-check.
Baumol’s model just uncovered how the banking system and financial advisors misguide people with low net worth.
Thanks to their lax spending habits and the fact that expenses represent a large part of their net worth, math dictates, that they will lose on fees more than they earn from the interest rate.
Even though Baumol’s model is a great improvement over general bro-science advice, in certain cases models don’t cope well with high uncertainty in monthly expense fluctuations.
Imagine a case when Jane convince Mr. Right to move into her apartment after only 6 months of dating. As a token gesture, Mr. Right offers to pay for her rent every second month.
Suddenly Jane’s living expenses fluctuate between $900 in one month and $400 in another so the calculated optimal balance is not optimal anymore.
Unfortunately, Baumol’s formula won’t take this variance into consideration.
That’s why there is a second model to save the day.
Miller-Orr Cash Management Model
Two dudes named M.H. Miller and Daniel Orr got an idea to improve Baumol’s model by incorporating stochastic elements that deal with uncertain cash inflows and cash outflows.
The Miller and Orr model has something called upper control limit, return point, and lower control limit.
When your cash balance touches the upper control limit. You put the difference between the upper control limit and return point into a savings account.
When your cash balance crash below the lower control limit. You withdraw the difference between return point and lower control limit.
In any case, the amount of cash will always return to the return point.
The spread between upper and lower control limits (called z) can be computed using the formula below:
Let’s see how the Miller Orr model improves Jane’s cash balance. Make an assumption, that her minimum cash balance equals food expenses of $400, transaction cost stays at $2 and the interest rate is still pathetic 0.01% per annum.
Because her living expenses fluctuate between $400 for food only in one month and $900 for food and rent in the second month, her monthly living expense variance equals to 80000.
Adding numbers to the formula above results in the spread being equal to approximately $1290.
The lower control limit is predefined t $400 as she can’t go below or she will starve that month.
Upper control limit = $400 + spread = $1690.
Return point = $400 + spread/3 = $833.
The beauty lies in variability. As she increases spending, so is the upper control limit, because the spread is getting wider thanks to bigger variance. She won’t have to make withdrawals more frequently.
It’s math, trust me.
In reverse, if she decreases her spending, then the spread gets tighter, and the upper control limit gets lower. She can put more money into a savings account and earn more interest on deposit as a result.
It is beautiful, isn’t it?
Having a budget customized to your needs, behavior, and spending habits. Fully optimized to minimize transaction costs and maximize interest income on deposit.
I don’t know about Jane, but I am already psyched to use the cash management model to manage my finances.
If you are interested in a google sheet with prepared formulas, comment below or sign up for my newsletter.