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]
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I have found this very important and it will be more so as my husband and I are moving into retirement -with a significant cut in income(of course, we also no longer have a mortgage or any other debt). We are looking at our yearly expenses and our new income level.We want to rely as much as possible on our pensions and leaving our investments alone- we don’t to use them for “regular” expenses until/unless we have to do so. Our monthly budgets differ significantly because of how we pay out certain charitable contributions and how we handle medical reimbursements.
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J.D. –
In reading your post, the supporting evidence for an annual budget being superior to a monthly budget seems incomplete. Unless I misread the post, it sounds as if the research suggests that you’d be better served to repeatedly use 1/12th of your annual budget each month as your budget than to have a budgeting template and then use the previous month’s spending as a starting point adjusting (up or down) where you need to based on the experience of several previous months, adjusting for any new or special monthly expenditures you have (e.g. new home projects, new gym membership, etc.), and adjusting for any changes in income along the way.
This seems incongruous to me. Far be it from me to call myself the expert when compared with formal scientific research. It just seems illogical. If one has a budget that can be refined on a monthly basis, I cannot imagine how it would not be more accurate. On a monthly basis, you can do some validation of the budget and make adjustments.
That being said, I can imagine an annual budget to be the best STARTING POINT for someone who does not have a budget. It is a natural tendency to underestimate our spending the first time we budget. For first-time budgeters, I would think the best approach to be:
1. Make an annual budget and divide each spending category by 12
2. Prepare a spreadsheet that details your budget by category and allows you to track and compare your spending against that budget
3. Build into that budget a separate section to track annual expenses (e.g. car taxes, house taxes, insurance, etc.) and divide those totals by 12 so you know how much to set aside every month for those once-a-year “gotchas!”
4. Build into that budget an area where you can track the due dates and estimated amount of each of your recurring bills (e.g. car payment, electricity, mobile phone, etc.) so that nothing sneaks up on you
5. Track your spending against each budget category so you can refine your future budgets
6. Each month, make a copy of the previous month’s budget to use as a template for the coming month
7. Reflect on where your spending went over or under by category and adjust if appropriate (use this as an opportunity to discuss with any loved ones where you believe you are overspending and modify as necessary)
8. Adjust the budget for any new or eliminated (goodbye credit card bill!) monthly and/or annual expenses
9. Repeat steps 6 – 9 immediately after the final paycheck of each month in preparation for the coming month
This is how I’ve managed my budget and spending over the past two years and I find it to be remarkably accurate. By no means am I suggesting that this is the absolute best approach. What I’m suggesting is that this approach is far more accurate (for me) than to “guesstimate” my annual budgeting and divide by 12 each month. I believe that continuously refining and adjusting where necessary increases precision.
It may be that I’ve blurred the line between budgeting and tracking your spending. Maybe I’m splitting hairs. To me, their one in the same and budgeting is nothing if you pick numbers for a budget while ignoring your spending habits regardless of whether you choose those number annually or monthly.
Sorry for the long comment but this post seemed counter to my experience and I was curious as to other’s opinions. For what it’s worth, in your other (excellent) post on the Free Debt Snowball Worksheet, I made my template budget spreadsheet available to anyone who wants it. The link is here if someone is interested (http://avoidregret.com/2008/08/26/free-excel-budgeting-worksheet.aspx).
Thanks again J.D. for your hard work.
Adam
http://www.avoidregret.com
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I agree completely, but would tend to work more in the opposite direction:
* First, budget all monthly expenses. For montly expenses that vary greatly by season (heat or A/C), just take a rough average.
* Then, budget all annual expenses (insurance premiums, Christmas gifts, etc.) separately.
* Then, either multiply monthly expenses by 12 or divide annual expenses by 12 to normalize.
The other approach I’ve taken is to have a big monthly “misc” expenses category. So basically I might have these monthly expenses:
* Mortgage
* Home Utilities (broken down)
* Gas
* Misc
Its a little goofy since “Misc” is probably 30% of the total budget. But it works because there’s *always* something that doesn’t fall into the other categories. It encompasses pocket change expenses, bigger infrequent purchases, and annual/irregular but expected expenses.
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I am attempting to do this after several failed attempts at staying in a monthly budget. The only problem is trying to decide what is worthy putting aside for in separate accunts (saved each month) and what should be considered taken out of an emergency fund. I am finding it hard to justify have extra money set aside when I should be paying off high interest loans instead.
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We are trying to work towards a more precise budget for variable monthly expenses (gas, groceries, eating out, personal care, clothes, dry cleaning).
But for the past two years we have created an annual spending plan that includes all known expenses, our savings goals and the we leave a chunk of money for the variable monthly expenses (our allowances).
The annual spending plan works well for us and agree that thinking yearly you capture annual or semi-annual bills and expenses that you might not think about for the monthly budget (auto insurance, property taxes, auto repairs, gifts, home repairs).
What I do when creating our annual spending plan is to review a year’s worth of regular bills to figure out how much we spend annual on certain categories (think more A/C in the summer), I take all the annual, semi annual bills and add those to the list. I create escrow ING accounts for annual, semi annual expenses like property insurance and property taxes. Then I go through our check book and capture expenses like auto registration, gifts, donations, charity giving, travel, vacations and create categories for those expenses as well. For larger expenses (like travel/vacation, gifts, auto expenses) I set aside money in ING sub savings accounts.
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I don’t go by any strict monthly or annual budget. However, I try to allocate set amount annualy to buy stuff like clothes, electronic goods, vacations etc and then try to stay within my limits.
A Dawn Journal
http://www.adawnjournal.com
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I love how Quicken automates my budgeting. When my employer began offering pre-tax savings accounts for health expenses, it was easy to see in Quicken that our family spends $1500 in this category for each of the past three years. I set the savings account to $1200 per year to allow for health expenses that may not qualify for this tax-free benefit, and it has worked perfectly for three years now (2005-2008).
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I do it as you describe, and my starting point is generally the previous year’s actual (annual) expenditures. I have a number of bills that I pay only once or twice a year (insurances, taxes, contract renewals) that would be either forgotten or difficult to account for otherwise. At year-end I use Quicken to calculate the totals by category, and use that to forecast for the next year. The hardest part is trying to estimate how much some categories will increase for the next year. But in the end, my monthly budget is really just 1/12 of the year’s budget.
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I’m finding one of the best things is to significantly budget UNDER our actual income. By being frugal and keeping our budget artificially low, we’ll be able to build up a nice chunk of savings for unexpected expenses and long-term goals.
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I think I have a hybrid approach. I track my bank account almost a year or so in advance, with expected inputs and outputs (including transfers to savings, etc). I also track my savings accounts in the same way.
I record expenses on a daily basis, total them up for the week, and record them on a separate sheet that I use for comparing between months.
What ends up working most effectively is ensuring that I don’t go over the total amount per month (which is a set amount that is broken into semi-flexible categories).
In essence, I adjust on a daily, weekly, and monthly basis.
The whole set-up looks ridiculous, but is actually rather easy and enormously effective.
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What a great article JD.
The portion discussing “overconfidence” being a drag on one’s finances is something I absolutely agree with. Trying to then discuss that overconfidence with someone who displays it becomes interesting.
This is why I abhor credit cards. They are dangerous and simply poor financial instruments even if used “correctly” Overconfident users are SURE they will never get into trouble or pay interest and “positve” they will pay it off each month, until that month they can’t.
I also am a believer in looking at the entire expense of an item, and annual budgeting sure allows one to more accurately gauge the cost.
$4 bucks a day is nothing
$20 a week sounds like a little
$80 a month sounds like more, but still ok
$960 a year. That starts to add up. nearing a thousand bucks.
Seeing the cost over a large block of time helps in evaluating the true cost.
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I like Quicken for tracking expenses. As it was mentioned earlier, it automates everything and every new version offers a new and helpful feature.
Be well.
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We actually built our spread into a working annual budget that breaks down to weekly spending plans that allows us to easily factor in those bills that don’t fit neatly into a monthly budget. semi annual insurance costs, yearly taxes (car, house and income all due at different times), water and garbage that are not billed to us on monthly cycles either. Allows us to seperate out gas from maintenance for auto costs. We can easily plan out the kids activity fees, vacations and all the other misc costs that can add up to big dollars over the course of a year. Gives us a much better picture of where we are finacially and allows us better decision making when something such as gas prices causes such a big ripple in your plan.
Being that we look at it at a weekly basis, it’s much easier to see the results of long term plans and really get an idea of areas we may be over spending or underspending in.
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I agree, more or less.
What I personally do is I created a monthly budget and figured out how much I can save based on that. Then, I computed my annual expenses.
Rather than break that down over 12 months, I simply withdraw the money for annual expenses (like gifts, clothing, vacation) from a designated short term savings account and deposit it into my checking to cover the bill.
I have 4 bank accounts – a main checking (where I pay bills from), a main savings (where the portion of my paycheck that covers my monthly expenses is deposited into), another savings account(a short term account which covers my annual expenses as identified above) and an long term savings (emergency fund).
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because I get paid every week, I created a yearly budget and divided it by 50. This creates a 2 week “cushion” in my budget where I’ll have income, but not have to worry about expenses. I also take my monthly expenses and multiply each of those by 12, then divide by 50 to keep the 2-week “boost” in play.
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We were doing well until we got hit with two large unexpected expenses to the tune of $6000.00 each in the last three months.
One is for dental surgery. (My company offers no dental insurance.) We are still trying to figure out the best way to pay for this.
The other is for a home repair that had to happen and was not covered by our home owner’s insurance. We ended up applying for and getting a home equity line to pay for this and some other basic work that we will be doing to the house.
Our $1000.00 emergency fund is no where close to being able to help us cover these unpredicted expenses.
We paid off nearly $15,000 in credit card debt last year. So, we will recover, but these expenses are not helping us pay off the total debt any faster.
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I don’t budget, but this probably makes more sense considering I have several expenses that only occur quarterly, annually, or semi-annually.
I find budgeting terribly inefficient, and this doesn’t help things.
I mean, if I had a monthly budget there would either be a huge difference month to month or I would allocate a prorated expense with money just sitting somewhere for several months. I don’t know.
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I have just finished setting up my annual budget starting with Sept 1st. I started with Dave Ramsey’s book, Total Money Makeover, and have set aside my $1,000 emergency fund. I hope to have my credit cards paid off by the end of March and hope to have my emergency fund increased from $1,000 to close to $8,000 in the next 12 months. I like seeing my money flow through an annual budget. We are paid on a weekly basis, so every few months there is a “5th” paycheck that goes mainly to pay off debt, or to the emergency fund. I am just getting to the point where I feel financially confident after my divorce 5 years ago. Thanks for the great site. You keep me motivated!
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I do pretty much the same thing as jb: I use a monthly budget (because many of my expenses come in the form of monthly bills), and then I average the irregular expenses, knowing that in these categories, I will go over budget in some months and under budget in others.
I use an Excel spreadsheet to track my budget and spending, and I have one sheet for each month, plus a summary sheet for the whole year. That way, I can see how I’m doing for the month as well as for the year.
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i have a budget that includes the monthlies, and the annual/intermittant divided by 12. when i actually added up the money for the annual/intermittent bills it came up to a surprising 572 dollars every two weeks.
before, i would have paid the monthly bills and gone shoppping. thanks to Mary Hunt and her book Debt Free Living. (the freedom account)
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I’m an advocate of the yearly budget and I think I am exactly the type of person the article was talking about as I tend to overestimate just so I know I won’t get caught out. For example, if I look at my past bills for car insurance, registration and autoclub membership (which happen to all be due on the same day each year so I throw them into one category) the total cost is about $600 and I add about 20% to this making it $720 in my budget. This year I was lucky because I totally forgot that my license renewal was due (it only happens every 5 years so easy to forget) and as it came to $120 I was 100% covered in my budget. For other items I just round up to the nearest 100 or 1000. I’m lucky in that I don’t have any debt which makes things easier, if I did I would throw every spare cent at the debt.
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My wife and I have different pay periods. Bi-weekly and bi-monthly, so I ended up with a budget that does yearly/bi-monthly/monthly/weekly all at the same time. I set it up with categories in one column and 5 columns that break expenses/income down yearly/monthly/weekly etc.
For example, if I need to budget a monthly amount, I enter that amount in the monthly column, and use formulas to figure out the yearly/weekly amounts.
Yeah, I know I could have just banked 2 of my bi-weekly checks a year and average it that way, but I am a glutton for punishment. When I started the budget, things were tight so that really wasn’t an option.
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I find the opposite to be true (personally) an annual budget contains very large numbers even if they’re broken down or averaged per month. I break my budgets down to a weekly level and adjust my spending accordingly. Granted this is in order to gain a strong hold on my spending. I believe that a monthly and yearly budget are important but rather than using one exclusively I think they should be used in tandem and adjusted as your spending needs change. December is most likely a more expensive month than February treating them with the same broad strokes might give a person with a tight financial situation a difficult time.
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Interesting perspective on budgeting.I think most people fail to stick to a budget because they find the initial task too overwhelming to calculate or they find that the numbers never come out correctly. I think if people use a yearly calculation and divide by 12, they may find it a more realistic way to create and stick to a budget.
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I think initially, obviously it’s much better to preduct your annual expenses and use that as an initial guide…but so many things occur on a monthly fee basis that you really have to check monthly to see how things are going. Try to pay routine fees like insurances less times per year instead of per month. In some cases you can save money because of transfer fees plus it gives you one less expense to keep track of during the month.
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An annual and monthly budget certainly aren’t mutually exclusive! I think an annual budget is a great tool for setting higher-level goals (fund the kids’ college, pay of $X debt, etc.).
However, when it gets down to the nitty gritty, sitting down each month where you only need to worry about that month is very effective. Also, when you have those higher-level goals as a guidepost for your monthly budget, you’re even more effective.
I suppose it’s akin to Covey’s ideas of values -> goals -> tasks or something like that. You set up the annual budget with your goals, and then you need to break it down into manageable chunks. Most people break it down into the monthly cycle.
One other reason, which may have been mentioned in the full study, is the fact that you have the law of averages working with you on an annual basis. Your spending would obviously revert to the mean over that timeframe, so your estimate would be more accurate.
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