The missing piece to building savings
The missing piece to building savings
How our best laid plans fall apart and what to do about it
“This is going to be the year that I finally get my finances in order.” I must have made that new year’s resolution at least five years in a row. Each time I did, it felt like the universe would find a new way to conspire against me.
The pattern always looked the same. An unforeseen expense like a car repair would wipe out months of diligent saving. The mental hit would then cause me to slowly lose confidence in my ability to meet my goals for the year.
After a period of self-delusion, I’d throw my hands up and finally admit that I was no longer trying, and I’d regress back to my old spending habits until the next new year’s resolution.
Only in hindsight did I realize that my emotions were not only running the show, but also flying blind.
I lost the horizon
Early in their training, pilots learn about a phenomenon known as spatial disorientation.
When they lose visibility to the horizon, their bodies struggle to tell if they’re flying straight. Without a visual frame of reference, the flood of incoming sensory signals incorrectly combine to produce a false sense of reality.
In the early days of aviation, before modern instruments, pilots would regularly leave a dense bank of clouds completely shocked to find they had been flying upside down.
A similar condition happens with our finances. In the absence of a financial “horizon line” our ability to tell if our financial lives are getting better or worse is severely impaired.
This happens for a few reasons.
We don’t account for future expenses
Your lifestyle costs more than you think.
If you total up the annual, semi-annual, and quarterly expenses you’ll have to pay this year, and level them out into a single monthly expense, you’ll see that no single month is representative of everything you have going on.
I call this monthly average your Scheduled Spending Overhead, and it can add up to as much as a third of your total monthly spending. If you don’t know this number, you’ll systematically underestimate your spending and set savings goals that are too high.
We miss seasonality
When you’re navigating by feel, recent events tend to influence your thinking more than events that happened a while back. This is classic recency bias, and it makes you miss the seasonal patterns in your life.
If you’re forecasting your expenses for the year in June, it’s easy to forget what your heating bill looked like in January.
Being unaware of how your spending changes with the seasons causes you to set unrealistically high savings goals.
We don’t distinguish regular from irregular spending
Not all spending is the same. A big expense needed to handle an emergency repair doesn’t represent how you lived your life for that month.
When assessing how well you live within your means, these large and reactive expenses eclipse the progress you’ve made, ultimately leading to a distorted view that can erode your financial self-esteem.
We lack context
A pilot would never commence a nose dive when they’re too low to the ground. They have to reach cruise altitude before it’s safe level out or descend. The same is true with building savings.
In this analogy, your savings level is like the height of the plane. You hit “cruise altitude” only after saving enough to fund your Rainy Day expenses, which is the Financial Resilience milestone on the path to Financial Serenity.
Buying that couch that “you just gotta have” before achieving cruise altitude means, at best, not climbing as fast as you could. At worst it means losing altitude when you’re still flying low to the ground.
Most of us have a rough idea of our savings level but are foggy on how quickly we’re climbing (or descending). Without both, it’s easy to justify large expenses that keep you from breaking through the clouds.
5 signs that you’re flying blind
The hallmark of flying blind is uncertainty. If any of the following are true, you’re likely flying upside down:
You consistently end the month keeping less of your income than expected
You have no idea how long it’ll take to finish building savings
You don’t know how much to ask for during your next raise or job interview
You suspect that you might be happier working a job that pays less, but don’t know how little you can afford to make
You only have a fuzzy idea of how long you could live off savings if you lost your job
Savings Capacity: your pitch indicator
The way you bring your perception in line with reality is to determine your monthly Savings Capacity.
Savings Capacity: The dollar figure you get by subtracting your Everyday, Debts, and Scheduled Spending expenses from your monthly income.
Back to our airplane metaphor, Saving Capacity is your pitch, the angle that describes if the plane is climbing, level, or descending.
The larger your Savings Capacity, the steeper your climb.
A Savings Capacity of $0 means you’re flying level.
The more negative your Savings Capacity, the steeper your descent.
As the name implies, your Savings Capacity is the true measure of your ability to save, unburdened by the noise of life.
The car repair that came out of the Rainy Day category isn’t included in your Savings Capacity. Those were dollars you put away long ago and they don’t tell an accurate story about how well you saved in the month you spent them. Savings Capacity filters out this noise.
By contrast, the night out on the town that ended up costing way more than you expected is fully captured by the Everyday category (first red bar in the chart), which results in a lower Savings Capacity for the month.
Since we’re all creatures of habit, your Saving Capacity is remarkably stable and well suited to forecasting. This is the number to use when building a savings plan that’s actually realistic.
Finding the horizon
Once you know you how to determine your Savings Capacity for one month, you can look back and calculate a nine or 12 month average. These averages address that pesky seasonality blind spot and allow you to accurately predict how long it’ll take to reach your savings goals.
The averaged Savings Capacity figure brings another huge advantage: It reveals your monthly Scheduled Spending Overhead. Remember, this is the figure that comes from leveling out all of your annual, semi-annual, and quarterly expenses. You only know the true monthly cost of your lifestyle when you know this figure.
Finally, when you pair your Savings Capacity with your current savings level, you have all the information you need to understand the stakes involved in any large purchase decisions. Going back to our example earlier, buying that gotta-have-it couch could very likely look like this:
When you know your Savings Capacity, you instantly begin to trust yourself again. The information you’re working with is well-informed, accurate, and stable, and it allows you to set goals that are sustainable and within reach.
Figuring this out was an absolute game changer in my personal savings journey. Being able to discern regular from exceptional spending allowed me to keep my head up and stay the course when the waters of life got unexpectedly choppy.
By knowing how my little airplane was climbing in periods of employment, and descending when I was between jobs, I was able to keep a realistic set of expectations about my savings journey and accurately choose my next goal.
Not only that, but I was able make confident decisions about which expenses to cut and how large of a salary to negotiate at the next job offer.
How to determine and use your Savings Capacity
Start or (re-start) using budgeting software. I love YNAB
Organize your budget with the Standard Category Groups
Determine your Saving Capacity
Calculate your 12-month (or next longest) average Savings Capacity
Identify your next milestone on the path to Financial Serenity
Track your progress by reviewing how these figures change every month
Having this knowledge at my fingertips helped me keep my emotions at bay and finally allowed me to make sense of my finances in a way no other tools had before.
Spend a few hours setting up your budget today, and start flying with a full set of instruments.