If you struggle with keeping a budget, it may be because you’re trying to predict your spending in time chunks that are just too small. A new study published in the Journal of Consumer Research found that people who made annual budgets were better able to predict their spending than those who made monthly budgets. From the University of Chicago press release:
[Researchers] found that, contrary to popular advice, people were more accurate when constructing an annual rather than a monthly budget, even when they were logging their expenses weekly.
“Consumers’ default tendency is to underestimate their budgets, for both next month and next year frames,” write the authors. “However budgets for the next year are closer to recorded expenses because consumers feel less confident when estimating these budgets, and therefore, adjust them upward.”
One reason yearly budgets are more accurate is that consumers consider a greater number of expense categories when they construct them. If you construct your monthly budget in April, will you remember to include a category for Christmas gifts?
Yearly budgets aren’t very useful, however, for planning your day-to-day spending. The obvious solution is to take the best of both worlds:
- Since people generally do a better job of estimating yearly expenses rather than monthly expenses, create an annual budget.
- Once you’ve arrived at your annual budget, divide your estimated expenses in each category by 12. This will give you a monthly number to work with.
The results of this study reiterate that over-confidence is an enormous drag on the average person’s finances. We believe we’re immune to advertising, that we can handle credit responsibly, that we can pick winning stocks. Yet study after study demonstrates that this just is not the case. In fact, those who lack confidence often make the best financial decisions.
This is also true with budgeting. In this study, subjects who were told that budgeting was difficult made more accurate estimates regarding their expenses than those who were told that budgeting was easy.
[Journal of Consumer Research, August 2008: The effect of ease of estimation and confidence on budget estimates]