Finding Your Magic Number
It is not about how much money you make. It is not about how much you spend. But it is all about the relationship between the two! I have worked with clients with astronomically high incomes but they are still destined for financial failure because they spend more than they make. I also work with clients who are not extraordinary income earners but they have net worth in the millions of dollars because their standard of living is far below their income.
I have always told clients that knowing the cost of their standard of living, their "magic number", is critical to developing a long term financial plan. Yet most people have no idea what their actual cost of living is and believe it would be difficult to figure out. When I first wrote on this issue in 2007 I recommended using financial software to quantify your spending patterns. But I was working with a client on their retirement plan recently and they don't use any software; they simply balance their checkbook by hand. Since they are spending less than they earn, their bank balance continues to increase and that is all the tracking they have done to measure their spending. She also told me that the thought of going through her checkbook and categorizing all her spending for the past year was about as exciting as root canal. And that's when I made the realization that in terms of knowing your magic number, it doesn't matter what you spend your money on – only that you know how much you spend.
It is easy to quantify total spending with only your checkbook register.
- Start with your January 1 bank balance
-
Add in the amounts you deposited to the account over the year including
- Net paychecks
- Withdrawals from savings or other accounts
- Irregular income and windfalls
- Subtract any amounts you invested or added to savings
- Subtract your December 31 bank balance
- The result is your annual spending
For example, suppose someone has $20,000 in their account at the start of the year, $28,000 at the end of the year, takes home paychecks of $2500 every other week (26 times a year), made savings account withdrawals of $12,000 during the year, and added $40,000 to their savings and investment accounts during the year. Their spending calculation is 20,000 + 65,000 +12,000 – 40,000 – 28,000 = $29,000 for the year or $2,416.67 per month.
Now that we know the expenses, we are much better equipped to develop a retirement plan or even know how much to keep in cash reserves.