There are four aspects of personal finance that we deal with every month, unlike taxes and insurance which are typically annual affairs.
- Income
- Debt
- Expense
- Asset
Thus the I, D, E, A is what one deals with every month – month after month in that same order.
Typically a household finance (or monthly cash flow) goes like this:
Income (I) -> Pay Debt (D) -> Pay Bills (E) -> If left over, invest in assets (A)
The problem is that the IDEA is wrong. It will never make one financially independent as the Asset part is only an afterthought, and mostly never happens.
This requires a correction in perspective and is much touted by financial advisors as Pay Yourself First, where A should come before D and E.
So the IDEAL sequence is I,A,D,E,L.
Income (I) -> Pay for Assets (A) -> Pay Debt (D) -> Pay Bills (E) -> If Left over (L), have fun.
The last part if consistently found to generate surplus, can also be adjusted for subsequent months to increase the “Pay for Assets (A)”.
How does one do this course correction? Here is one simple technique.
- You know how much Income comes in.
- Decide a percentage (start a bit aggressive, like 20%) to set aside for A.
- But do not invest yet, just set it aside to another savings account.
- Pay your debts (D).
- Pay your bills and monthly expenses (E).
- If shortfall, pull a bit from the A saved aside.
- If not, good news. Invest the 20% into assets (A) and enjoy any surplus (L).
This habit if done over 3-6 months, will build the automatic flow of savings and investment.
The sequence described above has the following automatic advantages.
- It starts with an aggressive savings goal of 20%.
- As one sees the expenses budget drying up towards end of the month, it encourages one to cut unnecessary spending.
- The savings is still saved aside till the end of the month, so can be pulled in if needed.
- Pulling in the savings every month however has a mental resistance, hence should be difficult to do month after month.
- To make it more difficult, put the A into another bank so that the transfer will take some time and effort to execute.
- As one adjusts to a comfortable level of savings (A) percentage, it brings in awareness of how the budget and cash flow works.
The IDEA is not so bad after all, you just need to fit it in the right sequence to work.
- No coupon cutting
- No writing down daily expenses
- Automatic resistance to debt
- Steady build up of assets.
