Can Budgeting Help Us Improve Our Personal Finances?

“What does it take to waste $10,000 a year? Just $27.40 a day in misc. spending.” – Post on Saving Dollars and Sense Facebook group.

The conventional wisdom is crystal clear. If you want to understand how you are spending your money, achieve your saving goals, and improve your personal finances, one of the most effective things you can do is to start budgeting. What’s more, the theory behind household budgeting is based on common sense and is well-established by a body of social psychology research. Budgeting involves two main activities: making a household budget and tweaking it periodically as needed, and then following it every month.

The value of making a budget

Let’s consider the value of making a budget first. When someone sits down and writes out a household budget for an upcoming month, they are doing several things at once that are good for their finances. First, they are taking stock of their personal finances by reinforcing their understanding of things like how much they earn each month, how much debt they have, how it is distributed, etc. As I’ve written before, increasing financial self-awareness helps the person to make better financial decisions.

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Second, making a household budget establishes concrete categories for the individual’s financial activities. These categories may include rent, utilities, vehicle expenses, groceries, eating out, saving for retirement, and so on.

Third, writing a budget is an implicit form of financial goal-setting. The individual has to decide how much to spend on discretionary items such as entertainment and eating out, how much debt to pay down each month and how much to put in savings when they write a budget. These are significant decisions. The fourth value of making a budget is that it provides a motivation boost which is important in the domain of money, where there are so many temptations and so many ways one can go astray.

The value of sticking to a budget

Following a budget each month and making sure to stay within the established boundaries for the budget categories is beneficial. First and foremost, following a budget gives the person a clear direction when making everyday decisions. For example, if I budget $75 per week for eating out, I now know exactly how much leeway I have in buying lunches outside vs. packing a lunch from home, or in deciding whether to splurge for an expensive dinner and then eat at home for a couple of weeks to compensate.

Second, following a budget diligently is a persuasive form of self-control, increasing the “pain of paying.” Once the $75 “eating out” budget is used up for the week, for instance, that is a concrete reason to no longer consider eating out that week. And third, on the flip side, since saving money is now a deliberate part of the person’s monthly financial planning, following a budget equates to saving money regularly, whether it is for retirement or for some other specific purpose like a wedding, a vacation, or a child’s education.

However, the big caveat about budgeting effectiveness

If household budgeting is so powerful, why are so many Americans still struggling with money? Just browse the media or the academic journals covering personal finance issues, and the most common theme you’ll find is the one about the widespread grave condition of Americans’ personal finances.

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A fair number of people say they use household budgets. For instance, in self-reported data collected by various commercial organizations over the past few years, anywhere from 41% to 67% of Americans say they budget their money. However, a closer look by more rigorous studies suggests that most of this self-reported budgeting activity is informal and incomplete. For example, one Dutch study found that a majority of people who said they budgeted admitted they did not make a written budget or cover all spending categories.

Randomized controlled trials that study whether initiating budgets and then using them actually works are hard to do and aren’t common. The ones that have been done have found discouraging results. For example, one RCT done with Indian migrant workers in Qatar found that teaching budgeting in a broader financial education workshop did not have significant effects on outcomes like savings or remittances. Another survey-based study done by the Financial Consumer Agency of Canada found that many of those who don’t use budgets don’t know where to begin, and have difficulty distinguishing between needs and wants.

Although budgeting is a useful practice with potentially huge payoffs, the truth of the matter is that it is a difficult practice, especially for those who haven’t used it before. There's a lot to know and think about before you can write your first budget. It’s even more difficult to persevere at, month after month. In many respects, household budgeting is similar to researching and choosing a diet that will work for you and then following it religiously over a long time period, no mean feat. It requires a great deal of resolve, not to mention skills, knowledge, and self-understanding to be able to use a budget regularly and effectively. The ones who benefit from budgets may be the very people who are good with money in the first place and don't need budgeting as much.