Personal Finance as a System

When personal finance is working smoothly, it should be like a well-oiled machine. There are many parts that work together toward success. As in any system, different pieces can bear different loads or even compensate for each other. The system has two purposes, providing a quality of life in the present and financial independence (or retirement), which provides a quality of life in the future, when you no longer work. The successful outcome depends on each piece working together, and a contingency plan in case one piece breaks down. Let’s look at the pieces.

Income. This is generally earned income. Just earning a high income isn’t enough, by itself, to guarantee success. Once the entire system is working, however, increasing income has the effect of improving the outcome. Income might be interrupted due to disability or death. This can be protected against through insurance or by saving a larger percentage of income.

Spending. Spending is necessary to provide a certain quality of life. Too little spending may be unhealthy, while too much is wasteful. The amount saved is simply the difference between Income and Spending, so widening the gap, by increasing income or reducing spending, improves the outcome. The spending piece can fall off track by impulse spending or unexpected repairs or replacement. This can be protected against by having an emergency reserve and through either budgeting or producing financial statements.

Saving. Saving is less a piece of the system and more a by-product. When money is left over at the end of the month, through spending less than your income, it’s important to have a plan for what to do with it. It could either be a monthly task (eg. transfer excess cash to savings account) or a pre-authorized or automatic transfer. This way, the money won’t work it’s way into the spending amount for the next month.

Repaying Debt. This isn’t necessarily a piece of everyone’s personal finance, but with house prices as they are, it’s highly likely. Repaying debt is much like saving, and for most people it’s automatic. The interest cost is a leakage of the system, reducing its overall efficiency. Repaying debt as quickly as possible puts and end to this leakage and makes cash available for saving and investing. Repaying debt could be interrupted by an interruption in earnings, and the result could be default. This can be protected against by having a more flexible loan (eg. line of credit instead of mortgage) and by having an emergency reserve.

Investing. This may be an entire sub-system, with different types of investments working together. The purpose of this piece or sub-system is to provide income to replace earned income, in order to fund spending. Savings will no longer be required and the system will be more efficient if debt repayment is complete. Investment income can be produced by interest, dividends, capital gains, or any combination of these. The choice will likely be dictated by the preference of the investor. Investment income could be interrupted by a postponed interest payment, a reduced dividend, or a drop in market value. This can be protected against by diversifying income sources and by producing slightly more income than required, which may be reinvested or redirected towards the emergency reserve.

This is the so-called view from 30,000 feet. All personal finance decisions can probably be seen as contributing to or working against this system. Choices may improve or decrease the overall efficiency. When we keep in mind that the purpose of the system is to produce quality of life, it’s easier to remember that decisions don’t depend only on financial considerations. For the system to produce the desired outcome, all the pieces need to be working together as efficiently as possible.