Mechanics of Money -- Benchmarks, Metrics,
Mental Exercises and Rules of Thumb

This is the section of the site for a Financial Freedom Community member to share a money management tip, a personal finance benchmark, a personal finance metric, or some lesson learned about the mechanics of money.

Money Management Tip #1 -- The Irregular-Income Worker

Most budgets assign a fixed amount of monthly earnings to various spending categories. What if you are self-employed or work on commission and, thus, do not earn the same amount of income each month?

My suggestion is to keep a three-tier budget. Divide expenses into three categories: (1) essential spending (health insurance, groceries); (2) nice-to-have spending (moderate-price vacations, eating out); and (3) luxury spending (an addition to the house, vacations that involve plane travel).

The irregular-income worker should not spend on any luxury items until there are enough earnings accumulated to cover essential spending and nice-to-have spending for at least a year into the future, preferably two. He or she should not spend on nice-to-have items until there are enough earnings accumulated to cover essential spending for at least six months.

So long as the budget is updated monthly, the worker has a warning whenever things are getting tight and is able to cut back spending in time. The other side of the story is that he or she never needs to deny himself or herself nice-to-have items or luxury items that he or she is truly able to afford.

Money Management Tip #2 -- PPx2/3/4

A Vanguard Diehards poster named "Adrian Nenu" has put forward a rule of thumb that you can use to determine your stock allocation. The rule is to take your "maximum tolerable loss" and to multiply it by two. I think of it as "Panic Percentage Times Two," or "PPx2."

I've determined my Panic Percentage to be 20 percent. I believe that, if I were to suffer losses of more than one-fifth of my accumulated life savings, I would become sufficiently distressed to feel a need to take some sort of action. I might be driven to sell stock shares at the worst possible time for doing so. So I aim to keep my stock allocation to a percentage low enough so that I am not likely to experience a 20 percent loss in my overall portfolio value.

The PPx2 rule suggests that I should be going with a 40 percent stock allocation. I think that's a bit on the high side. I think an allocation of 25 percent stocks or 30 percent stocks makes better sense for the typical middle-class investor when we are at the price levels that apply today (because I am taking on the risk of starting a writing business, I have elected to go with a zero percent stock allocation for the time-being). Still, those numbers are in the same general neighborhood. I think the PPx2 rule works reasonably well at today's valuations.

It suggests too low a stock allocation at times of moderate or low valuations, however. The "times two" part of the rule is rooted in an assumption that we are not likely to see a drop in stock prices of much more than 50 percent. Such price drops are common at times of high valuations (like today), but they are not at all common at times of moderate valuations or low valuations. Since stocks generally provide higher long-term returns than alternate asset classes, it makes sense to buy more stocks at times when the risks associated with stock investing are diminished.

At times of moderate valuations, I think that a PPx3 rule makes better sense. For someone who shares my Panic Percentage of 20 percent, that translates into a stock allocation of 60 percent. That's only a bit higher than my usual recommendation that the typical middle-class investor go with a stock allocation of about 50 percent at times of moderate valuations.

At times of low valuation, I think that a PPx4 rule makes sense. For someone who shares my Panic Percentage of 20 percent, that translates into a stock allocation of 80 percent. Again, that's only a bit higher than my usual recommendation that the typical middle-class investor go with a stock allocation of about 75 percent at times of low valuations.

Rules of thumb should never be applied dogmatically. They are useful, though, to get your thinking about a personal finance question into the right ballpark. Change the PPx2 rule into a PPx2/3/4 rule, with variations in the stock allocation to reflect changes in valuation levels, and it provides helpful guidance on determining a starting-point number to which you can make adjustments as you engage in more in-depth investigations of the issues at play in making a customized stock-allocation decision.

Money Management Tip #3 -- Covering Depreciation on Non-Income-Producing Assets

The money you spend to purchase an asset is often only the first payment you will make to obtain whatever life enhancement you obtain from possession of that asset. After you pay for a car, you have to pay for insurance and repairs and gas. Somewhere down the line, the car is worn out and you need to purchase a new car to maintain the lifestyle to which you have become accustomed.

“TheBadger” argues in a thread from the Glory Days of the Motley Fool board that those seeking early retirement should calculate the ratio of investable assets to total assets. He says: “The banker always applies two tests: an asset test (loan-to-value) and an income test (mortgage payment divided by gross income).... The asset test equivalent [for aspiring early retirees] is non-income producing assets divided by total net worth.... I don't think this percentage can go over 15% to 20%; because, if it does, the theoretical feeding of (depreciation on) the non-income producing assets becomes too high to be supported by the income stream from the income producing assets.”

TheBadger provides this illustration of how his metric works: “Let's say Bob has $2,000,000 in investable assets; thus being very safe Bob can withdraw $70,000 (3.5%) per year. Bob also figures out that he needs $40,000 to feed himself (food, clothing, shelter, entertainment) and needs $20,000 to feed others (governments, charitable giving, etc.). This leaves $10,000 a year to "feed" or replace durable goods (cars, boats, stereos, etc).

“If Bob has $500,000 now of non-income producing assets; e.g. durable goods; then his ratio of non-income producing assets to total net worth is 20% ($500k / $2.5mm) and it is too high. With only $10,000 per year to work with, his average durable good has to last 50 years, which won't happen. In short, Bob cannot support a steady-state lifestyle because he will run out of money trying to periodically replace durable goods. Bob really needs more like an extra $50k on the presumption that all of this stuff lasts 10 years on average (cars potentially shorter but refrigerators longer).

“Conversely, if Bob has $100,000 of non-income producing assets; then his ratio is 4.76% ($100,000 / $2.1mm) and his average durable good has to last 10 years, again on average; potentially very doable.”

Money Management Tip #4 -- Applying Value Analysis to Life

Juicy Excerpt: I arrive at my job, which my boss insists is a meaningful one, but which I know deep down is nothing more than shuffling papers around for someone else's benefit until the time comes to clock out.... It's no wonder we live in an overly material, commercialized, consumer-driven society. Most people need to treat themselves frequently with expensive items to make up for the lack of lasting fulfillment in their lives.

The trick I believe is to apply some investment analysis to our lives. The analogy is an appropriate one, I think.... After all, isn't that what we do every day - invest in ourselves one way or another? Actually, most people seem to apply the wrong kind of analysis.... They apply a kind of technical analysis, whereby they add up all the assets they own, expenses, cash flow, balance sheet, etc., to figure out where they are in their lives. I suggest value analysis instead. Look at things like how much time is spent enriching your life. What are your goals and how does your current routine help to accomplish them? How much freedom do you have? Are you happy? How much of your life is really your own, and how much of it is owned by someone else? What is your real worth (not measured in dollars but in self-esteem, freedom and passion)?

Rob’s Comment: It’s life that matters, not money. Money only matters because it opens up the opportunity to do more exciting things with your life. It’s easy to count dollars. It’s hard to quantify the life stuff. But we must do the best job we can if we are to make sense of money management questions.

You are always either giving up life to get more dollars or giving up dollars to get more life. To make meaningful comparisons, you need to make an effort to quantify the value of life goals than cannot in any final sense be quantified.

You will not be completely successful in this endeavor. But you will learn a lot by engaging in it.

Money Management Tip #5 -- The 60/40 Rule for Allocating Spending

Janine Bolon is the author of Money...It’s Not Just for Rich People. She recommends a 60/40 rule for dividing up your money on the way to becoming a middle-class millionaire.

She recommends that 60 percent of your spending be directed to covering living expenses, that 10 percent be directed to a tithe, that 10 percent be directed to philanthropy, that 10 percent be directed to short-term savings (to cover emergencies) and that 10 percent be directed to long-term savings.

She says: “I started with no tangible assets two decades ago, and now my husband and I have enough so that we don’t need to work. More importantly, we did this without any special talents: no extraordinary genius in investing, or ability to play professional sports, or luck in winning the lottery. No, we are financially independent because we spent those years learning the true principles of successful wealth accumulation -- and then using them.” Moreover, “I have been teaching these universal principles for almost a decade and have seen remarkable changes in the lives of my students and my clients.”

Rob’s Comment: Janine gets the critical money reality that many big-name personal finance advisors do not -- that it is by coming to terms emotionally with money that you set yourself on the path to accumulating lasting wealth. This is the breakthrough of recent years that has not yet been given sufficient recognition, in my view. The emotional stuff is 80 percent of the question and the practical stuff is 20 percent, yet 80 percent of the literature is directed to an examination of the practical.

Janine brings an unusual combination of “vision” and “action steps” to the table. Throughout her book, she is careful to reduce things to action steps, which keeps things real. But she starts things off by looking at the big picture. These two skills don’t usually appear together in the same personality. It is the combination of them that makes her money strategies work for those who come to her for advice, in my assessment.