A practical application of economics is budgeting.
Human beings have unlimited needs and wants but also have finite resources such as money. Therefore, choices have to be made so that we maximize what we need and what we want based on what we have. Choices can still make us happy even against the backdrop of an imperfect world.
A popular budgeting framework is the “50-30-20” budget framework. In this framework, 50 percent of monthly income goes to needs, 30 percent goes to wants and 20 percent goes to future funds.
What should be the basis of the budget?
The answer is monthly income. This should serve as the roof through which all components of the budget will adjust accordingly. If we spend beyond what we earn, we will run the risk of accumulating debt and this will be cumbersome.
The Covid-19 pandemic has disrupted a lot of cash inflows. Hence, active income can be generated by knowing what the talents and available resources are. Passive income can be generated by identifying the “New Normal” opportunities.
Given the new world, it is an opportune time to finally change the “50-30-20” framework to the “20-50-30” framework. We must pay ourselves first. We must set aside funds for the future at the onset.
The first step in the 20 percent component is to save. Savings support future consumption. Building an emergency fund provides a valuable buffer during uncertain times. The emergency fund can be maintained to a level that represents the value of monthly lifestyle expenses multiplied with around 6 months to 12 months.
Part of the 20 percent can go toward the settlement of loan obligations. Being able to settle debt provides financial and emotional relief. Paying short-term debt first can boost confidence in managing debt.
Another possible component of the 20 percent is insurance, which helps address risk. Insurance is like an umbrella that helps protect families from storms. In addressing risk, we need to protect ourselves in the form of life insurance and we need to protect the valuable assets that we own through non-life insurance.
Another possible component of the 20 percent can be investment. The choice of investment will depend on the clear goal, risk profile and time horizon of each individual.
Investments can help enhance purchasing power over time if earnings growth outpaces the inflation rate. There are many viable investment options in the Philippines like financial instruments, real estate and businesses. Part of the 20 percent can also be devoted toward societal aspirations related to health, environmental and development programs.
The next step in the framework would be to allocate 50 percent of the monthly income to needs.
Not all expenses are created equal. Needs should always be prioritized over wants. Needs are goods or services that are basic to human existence. The popular needs globally are those related to basic food, basic shelter and basic clothing.
With the “New Normal,” additional needs like health, safety, utilities and connectivity are emerging and therefore have to be budgeted for. Expenses on needs should be reviewed and optimized. The last step in the framework is to allocate 30 percent or whatever is left to wants.These are items that make life more pleasant but are really not that essential in living. A common synonym of a want is a luxury.
The opportunity in terms of wants is to review them and determine what wants can be taken out completely and what wants can be minimized especially if times are difficult.
Financial literacy is not about converting people to become misers. Fun is part of human nature but fun should be budgeted so it can be sustainable.
Having a budgeting framework like the proposed “20-50-30” budget framework can be an effective way of allocating income. Money will be set aside according to our priorities in life.
Managing money is important because if we take good care of our money today, money will be able to take care of us in the future.
Gemmy Lontoc is a registered financial planner of the RFP Philippines. To learn more about personal financial planning, attend the 86th RFP program this October 2020. To inquire, e-mail info@rfp.ph or text <name><e-mail> <RFP> at 0917-6248110.