How do we Spend, Save & Invest?. “A penny saved is a penny earned”. We all realize the importance of managing our finances well and how financial prudence can help us achieve our goals, yet how many of us really follow this in practice?
Today I am going to talk about the difference between what we should do and what we actually tend to do in financial decision making.
Have you ever sold a winning stock too quickly just to see the price going up further or continued to hold onto a losing stock (decreased in price) for long with the hope to recover losses from the same stock? This is a simple example of loss aversion bias. Behavioral biases affect our investment decisions, knowing these biases can help us avoid financial decision making errors.
Firstly, let’s discuss spending. Most of us have unlimited desires but very limited resources to fulfill them. I have seen people struggling in the last week of every month as they spent their entire salary in the first 3 weeks. There is a big list of expenses such as Housing, EMIs, credit card bills, entertainment, transport, and healthcare and so on. Some do shopping for a thrill, some like showing off beyond their means, some of us try to hunt bargain but end up buying more than what we actually need. One of the most successful American investors Warren Buffett said, “If you buy things you don’t need, you will soon sell things you need.” Some may argue that If you spend more you will try to find ways to earn more, others may say why to worry about tomorrow lets live today, well, nobody is wrong. My point is where you spend matters; do you pay yourself first before paying your bills? If we don’t manage our expectations and reality, we end up facing financial difficulties.
Now the second point, savings. People use the word savings and investments interchangeably; however, there are differences when we take a close look at them. Savings are usually for very short term and less risky thus lower return, the focus is on safety of money. Very simple example is a savings account with your bank which earns very low rate of interest; your banking partner is making money by lending at a higher interest rates. Investing is putting your money to work for you and earn higher return by taking higher risk (risk is measured by the fluctuation in price). A simple example of investments is your SIP (systematic investment plan) with a mutual fund, investments in a business, a commodity etc.
When we deduct our consumptions from our income we are left with a surplus, this is our saving. If we spend more than what we earn, then the savings will become negative which is our debt; Credit card is a common example. This is not a good situation to be in! Unfortunately, it’s very common. What to do in such a situation, well increase your income or decrease your expenses to increase your surplus every month. It’s so important that I will write a simple equation below;
Income – Expense = Surplus
There are enough reasons to save money e.g. creating an emergency fund, education for your child, getting out of debt, to have a good life, to help others or even do saving to save tax expense etc. In India, Employee Provident Fund is a mandatory saving instrument with tax benefits; people use savings bank accounts, jewelry as a savings instrument, physical commodity etc.
I will talk about investments and types of biases we face pertaining to our investments in my next article.