Earning, spending, and saving: The building blocks of personal finance

A couple of weeks ago, Robert Brokamp explained how living below your means is like saving for retirement twice. On the surface, his advice was pretty conventional: The more you save today, the more you'll have tomorrow. This is similar to a point I've been repeating for the past five years.

Smart personal finance can be reduced to one simple equation:

[WEALTH] = [WHAT YOU EARN] – [WHAT YOU SPEND]

If you spend more than you earn, you have a negative cash flow. You're losing wealth and in danger of going into debt. (Or, if you're already in debt, you're digging the hole deeper.) If you spend less than you earn, you have a positive cash flow, which will let you climb out of debt and build wealth.

But as I was editing Brokamp's article, I had a flash of insight. What Brokamp was trying to say — and what my little equation tries to quantify — is that basic personal finance comprises three essential skills:

  • Earning — your ability to bring in money.
  • Spending — your ability to live frugally and spend wisely.
  • Saving — your ability to produce a surplus and to make that surplus grow.

Some folks are good at one skill, but not the others. (Maybe you're good at keeping your costs low, for instance, but struggle to earn money.) Other people are good at two of the skills, but fall down on a third. Penrose Triangle(You might have a good income and keep your costs low, but have a small nest egg because you lack skill in saving.) And still others are passable at all three skills — not really excelling, but not failing either.

To be truly successful at personal finance, you have to maximize your performance in all three areas.

Mastering the Art of Earning

The first skill in this framework is your ability to make money. For most folks, this means managing a career effectively: finding the right job, learning how to ask for a raise, and so on. Others can up their incomes by selling stuff they already own, pursuing money-making hobbies, or starting their own businesses.

Here are some steps that lead to increased earning:

  • Become better educated. In general, the better your education, the better your income.
  • If possible, choose a career that you love — and that pays well. This isn't always possible, of course. But if you can get paid well to do what you love, it can almost be like you don't have a job at all!
  • Maximize your salary. This is probably your primary source of income, so make the most of it. Learn how to negotiate your salary. Make the most of your benefits.
  • Make money from your hobbies. Find ways to earn a little cash from the things you do in your spare time.
  • Turn your clutter into cash. When I was getting out of debt, I sold tons of Stuff previously bought on credit. I didn't get back what I paid for it, but that's okay. I got out of debt, which was even better. (Here's more about selling your stuff.)

Though some people don't like to hear it, high income is also associated with hard work. The folks who make the most money are often those who work the longest hours. Hard work doesn't guarantee a high income, of course — there are plenty of hard workers stuck in low-wage jobs — but it's tough to master the art of earning without hard work.

And here's another reason to enhance your earning power: As vital as it is to cut your spending, there's only so much you can trim from your budget. Your income, on the other hand, is theoretically unlimited.

If life were a game, your earning score would be easy to calculate: It'd simply be a measure of your annual income. The more you made, the higher your score.

Note: For more on this subject, see my colossal post about how to make money. It's a huge list of ways to boost your income.

Developing Discipline in Spending

While some people find it tough to boost their incomes, others find it tough to keep costs down. There are even those who believe that thrift is overrated, that it's somehow akin to deprivation. But those who dismiss frugality to focus solely on earning are missing a key piece of the puzzle. Your goal should be to create as big a gap as possible between earning and spending.

How do you do that?

  • Embrace frugality. A lot of folks are afraid to pinch pennies — they don't want to appear cheap — but frugality is an important part of personal finance. Learn to clip coupons, shop at sales, and make do with less.
  • Practice conscious spending. You can't always get what you want, so decide what's important to you, and make those things a priority. Cut corners on the things that don't matter.
  • Avoid paying interest. The power of compound interest can help you build wealth when it's on your side. But it can suck you dry if it's working against you. To cut your interest payments, Get out of debt and stay out of debt. Make it a goal to pay as little interest as possible.
  • Reduce recurring expenses. One-time costs can be painful, but ongoing expenses — like magazine subscriptions, cable television and cell-phone bills, etc. — can act like an anchor on your finances.
  • Focus on the big wins. Daily frugality is a valuable skill. It helps you save a little bit all the time. But if you really want to cut your spending, spend less on the big things, like housing and transportation.

If personal finance were a game, your spending score would come from how low you could go. The less you spent, the higher your score.

Remember: Your earning power might bring you wealth; frugality and thrift will help you keep it. By cutting your spending while you increase your income, you'll develop a cash surplus — a surplus that can be used for saving.

Note: For some reason, financial writers often fixate on spending. There's no question that it's important, but it's not the only piece of personal finance. It's one of three basic building blocks. If you embrace frugality but ignore your income and investments, you can't expect to build wealth. Each skill is essential.

Discovering the Secret of Saving

Often when I write about saving, I'm just talking about the difference between what you earn and what you spend. This surplus is important, no question — it forms the foundation of your ability to save — but skill at at saving comes mainly from what you do with your surplus.

If you hide your money under a rock, for instance, your skill at saving isn't particularly good. Anyone can do that. And though you might think you're protecting what you've saved, you're actually losing money to inflation, the silent killer of wealth. (If you use your extra money to play the lottery, I'd argue that your savings skills are especially poor!)

What sorts of things go into becoming a successful saver? This is where a knowledge of investing pays dividends. The secret of saving is to learn everything you can about making your wealth grow. Successful savers:

  • Understand the importance of creating a plan — and sticking to it. (This is where asset allocation and re-balancing come into play. I'll write about these more later in the month.)
  • Make logical decisions instead of succumbing to emotion. Successful savers don't make decisions based on breathless media pundits.
  • Avoid fads. They don't buy real estate just because everyone else is. They don't buy tech stocks just because they're riding high. And they're wary of gold when it's at record highs. They buy low and sell high.
  • Embrace diversification as a way to improve returns while reducing risk.
  • Constantly contribute their surplus income to grow their savings. They pay themselves first.

If there were a scorecard for life, your points for saving would be determined by how much you make your surplus grow, and by how well you protect the money you save.

Note: I used to do a poor job with all three of these skills. Over the past few years, I've become adept at earning, and I'm learning to be a better saver. My spending skill is improving, but remains the weakest part of my personal-finance package.

The Fundamentals of Personal Finance

None of this is earth-shattering; these notions form the core of smart personal finance. What is new — for me, anyhow — is thinking of earning, spending, and saving as discrete skills, building blocks that can be put together to form a greater whole. It's this framework that's new.

Mastering money means mastering each of these three skills. If you can teach yourself all about earning, spending, and saving — and put what you learn into into practice — you'll achieve your financial aims with surprising speed. But so long as one of these skills lags, you'll struggle to meet your goals.

Penrose blocks photo by gfpeck.

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Dan W.
Dan W.
9 years ago

Great stuff as usual! If you don’t have enough time to read a personal finance book and only got a few minutes to spend for a blog post, read this.

Bogey@BackNineFinance
9 years ago

This is a very timely post for me. I am giving a presentation to a group of people tomorrow who are part of a low income housing subsidy program in the city where I live. I have been struggling to really come up with some very basic items that will strike a chord with these folks. This piece is getting me into the correct frame of mind.

LifeAndMyFinances
LifeAndMyFinances
9 years ago

It’s amazing how simple personal finance really is when you break it down into these easy steps.

Earning, Spending, Saving.

Increase the first, decrease the second, and soon, your savings will be larger than you ever dreamed possible!

Prem Sagar
Prem Sagar
9 years ago

Great article, but I would prefer the equation to be this way:

WEALTH= (WHAT YOU EARN—WHAT YOU SPEND)*(HOW SMARTLY YOU INVEST+TIME)

Suzanne
Suzanne
9 years ago
Reply to  Prem Sagar

Agreed.

Suzanne
Suzanne
9 years ago
Reply to  Suzanne

Or:

Savings = Income – Spending

Wealth = Savings*[Investing over time]

John Sherry
John Sherry
9 years ago

Absolutely mega JD. It’s so amazing that in this highly technolgical computer driven age we’ve lost touch and sight of the simple things. Thanks for bringing it back for finances, a subject the world truly needs to get a grip on. One basic equation = one wise awareness.

Nicole
Nicole
9 years ago

I always thought of the extra money I make on investing and saving as additional earnings. The IRS certainly seems to think it is. And I would make more if I invested a little more time in the process.

Saving I think of as the residual just like Brokamp does in his equation.

I guess I would separate earnings into Earnings from work and Passive earnings, though Passive earning isn’t always as passive as I’d like. I guess it could make sense to lump passive earning into saving in a simple equation. Then you wouldn’t need a feedback loop.

CincyCat
CincyCat
9 years ago
Reply to  Nicole

I agree… Investment earnings are still “earnings”. They are not “savings” — unless you KEEP it (are not taxed on it, and don’t spend it).

Jen
Jen
9 years ago

Great summary post! Every once in a while I like to take a step back and look at the big picture of my personal finances. Since we’re moving to a new city soon, with new expenses/incomes, this post came at a great time! We’re doing pretty well on all of the points you mentioned (paying ourselves first, maximizing earnings, conscious spending), except for “reduce recurring expenses”. This is the hardest, because so many of these are long-term debts, like student loans at 3-4% interest, or my 0% car loan. If only I didn’t have these debts, our cash flow would… Read more »

Michael Sitarzewski
Michael Sitarzewski
9 years ago

Fantastic post. I’d suggest a tweak to the formula:

[WEALTH] = ([WHAT YOU EARN] — [WHAT YOU SPEND]) * [COMPOUND INTEREST]

🙂

Nicole
Nicole
9 years ago

Oooh, I like!

Lody
Lody
9 years ago

Great post. I hadn’t thought explicitly in terms of 3 separate skills before, but that framework could be quite useful. I guess right now I’m pretty solid on the spending and saving parts of the equation, but floundering a bit on the earning skills. I’m in business school right now because I could see my previous career dead-ending at a decent but unremarkable level of both earnings and responsibility. Thanks to good test scores, I have grants that will allow me to graduate with under $12k of student debt, but the fact that I still don’t have a clear idea… Read more »

El Nerdo
El Nerdo
9 years ago

@ JD Good outline, the only area where I’m left wanting is in the “maximize your income” side which is mostly geared towards the salaried. I checked out the “Make More Money” article linked, and while it was inspired by a freelance web designer, the article starts with “negotiate your salary” and later follows with “start a side business” Good general advice, but those mired in the running of their own businesses (like your web designer friend) likely need to maximize what they have rather than scatter themselves further. I do recognize that this isn’t a small business blog, and… Read more »

Jaime B
Jaime B
9 years ago
Reply to  El Nerdo

Agreed, though it might be straying from a strictly “personal finance” perspective. A reader story from a small business owner would be nice though.

Moneyman
Moneyman
9 years ago

Good stuff.

I have a similar formula which is:
Wealth Potential = Income – Expenditure
(as I think wealth is accumulated surplus, from which you can derive a passive income)

I recently worked out that saving $10 a day (actually £10, as I’m from the UK) was equivalent to an increase in wealth of more than $70,000!

Adam P
Adam P
9 years ago

Hey JD. I like this article except for this part: “You might have a good income and keep your costs low, but have a small nest egg because you lack skill in saving” Maybe it’s the accountant in me, but I don’t see how you could earn good money and not spend it, yet also not be able to save. What are you implying happens to the money you earn but don’t spend if it is not saved? Unless you suddenly decide to tear up the physical money you have, any “good” money you earn but don’t spend is, by… Read more »

Sara
Sara
9 years ago
Reply to  Adam P

This part caught me, too, Adam. So did: “If you use your extra money to play the lottery, I’d argue that your savings skills are especially poor!” Good point, but wouldn’t playing the lottery be considered spending? In any event, I thought this was a great post. It really helped me open up my eyes as to the importance of what you do with your savings. I have worked hard at the other two components, but have just let my savings sit in “high yield” savings accounts and money markets (plus retirement in Roth IRA and 401k). I’ve been thinking… Read more »

CincyCat
CincyCat
9 years ago
Reply to  Adam P

Because it’s easy to get caught in the “we can afford” it trap… Not with “frivolous spending”, but things like finally going on that dream vacation with the family (a one-time expense that drains the savings account), sending your kids to private school (because daddy/mommy got a promotion), increasing charitable contributions/tithing, etc. Not exactly “unwise” things to spend money on necessarily, but these are the people who have “good jobs”, but are always scratching their heads wondering why they live paycheck to paycheck & can never put away any savings. Technically, they’re still living “below their means”, but only JUST… Read more »

Adam P
Adam P
9 years ago
Reply to  CincyCat

I’d argue that if your good, frugal, not-frivlous spending is *just* under your income level, your problem is income and not with saving.

Justin
Justin
9 years ago

“Become better educated. In general, the better your education, the better your income”

I’m glad that you put the “in general” in italics there! I definitely have found this statement to be true, but have to say that there are tens of thousands of very successful people out there without college degrees. I personally got one, but I’m stopping at a Batchelors. Even if a “Masters is the new Batchelors”, I’d rather spend my spare time building a side business instead of getting another degree.

Catherine
Catherine
9 years ago
Reply to  Justin

Justin, darling, perhaps you could use a Masters in spelling.

Luke
Luke
9 years ago
Reply to  Catherine

Maybe he got his degree from a soup college? 😉

echo
echo
9 years ago

In addition to following these steps and building up your financial foundation each day, there also comes a few times in your life when you are faced with major financial decisions (buying or selling a house, moving, changing careers, marriage, divorce, investing a large sum, etc.) and it’s how you handle these decisions that will define your financial success.

El Nerdo
El Nerdo
9 years ago

BTW, rather than tweaking JD’s formula we could go back to the accounting equation, which in its sole proprietor version is

Assets = Liabilities + Owner’s Equity

or

Owner’s Equity = Assets – Liabilities

Equity is what in common parlance we call “wealth,” “net worth,” etc.

Apply to the personal sphere & the math is the same.

Jacq
Jacq
9 years ago

I wish you’d have a few more articles along the “do what you love” VS / AND “make money” vein. So many people that I see that seem to struggle and have to really pinch pennies are doing things that aren’t pulling in much money, if anything. Yet they are really resistant to giving up their dreams. I saw it a lot when I worked in small business lending – people would come in with the most economically unfeasible ideas and look for funding. Heaven forbid we would have given it to them and had them get into more debt.… Read more »

Marsha
Marsha
9 years ago
Reply to  Jacq

I agree that the “do what you love” idea can be taken too far. I would have loved to be a concert pianist, and although I was a solid and talented amateur, the chances were slim that I could make it a career. Instead, I turned my aptitude in mathematics and science into a career in engineering. I worked hard to become a competent engineer, and in doing so, I came to enjoy my career immensely. There no job that’s going to fun all the time, of course. Having a good attitude and looking upon work as a blessing and… Read more »

Tyler Karaszewski
Tyler Karaszewski
9 years ago

I think you should replace “saving” with “investing” in the formula, because otherwise it doesn’t work. If you’ve got: [WEALTH] = [WHAT YOU EARN] — [WHAT YOU SPEND] Where this equates to the skills of: saving = earning – spending Then if you’re good at any two of them, the third one falls into place. You give the example of being good at earning, and good with spending, but somehow being bad at saving. It doesn’t make any sense using that formula. If you earn a lot and spend a little, how can you possibly not have any savings? This… Read more »

Sam
Sam
9 years ago

I enjoyed this post. I’m not a math person so translating personal finance into an equation is beyond me, but I would add in somewhere as a multiplier (time and attention directed to finances).

I find that the more time and attention I gave my debt and that I now give my savings the better I do.

Steven
Steven
9 years ago

I think people are picking on the equation because as it’s written, the equation is actually about a “rate of change in wealth”, which is a function of time, not “wealth”, which is an amount. If I can nerd out for a second, and look at the units… Wealth (W) is a quantity expressed in $, but we usually think of “what you spend” and “what you earn” as having a natural span of time, say “per month”. Then, what you spend (S) is expressed in $/mth, and so is what you earn (E): $/mth. If you write the equation… Read more »

Jonathan
Jonathan
9 years ago
Reply to  Steven

Steven, I understand your point here (and the math behind it), but as long as you’re going to just assume that “what you earn” and “what you spend” are in dollars per time units, why not assume the same for wealth? Strictly speaking, the equation is correct as written. Time-independent wealth is equal to time-independent earnings – time-independent spending.

Steven
Steven
9 years ago
Reply to  Jonathan

Jonathan, If I asked you how much you earned, would you say “17”? I’m not going out on a limb when I say that it’s a function of time. Here’s the first two lines of the entry from Wikipedia on “Income”: Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms.[1] However, for households and individuals, “income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings received… in a given period of time.”[2] Both definitions involve an amount per… Read more »

Anonymous
Anonymous
9 years ago
Reply to  Steven

I think all the Equation responses are getting pretty old now.

Tanya
Tanya
9 years ago

The point about not succumbing to emotion really struck me. Even though my impulsive buys are always small, I regret many of them and end up with “clutter” because I shopped in the mood of the moment. Emotion and money together can cause so many entanglements …

CincyCat
CincyCat
9 years ago

The IRS seems to categorize dividends & interest as “income”, and tax it. For this reason, I would consider those moneys part of the “earnings” piece of the equation. If you got to keep 100% of it, THEN I would say it could be a “savings” multiplier, as some of the reader-supplied equations indicate.

brooklyn money
brooklyn money
9 years ago

I will say that I agree with this in general, but judging how good someone is at investing is difficult. A lot of your returns are arbitrary. I started investing in my 401K in the late 90s — so my portfolio has been devastated by the tech crash and then by the more recent real estate fueled general economy crash. There’s no way to avoid those market-wide conditions that lower your returns and ultimately your savings.

J.D. Roth
J.D. Roth
9 years ago

I’ve created confusion! I knew I would, so I tried to head it off in the article. But I failed.

Yes, saving is traditionally defined as the difference between earning and spending. I’m arguing that there’s more to it than that. But as Tyler noted, maybe “investing” is a better word. But then that leaves out the actual accumulation of the money. I want something that emphasizes the necessary skill of making the money grow. Maybe “saving and investing” is the appropriate phrase.

J.D. Roth
J.D. Roth
9 years ago
Reply to  J.D. Roth

Boy, I really really really want comment numbers back. Come on, technical elves! Do your thing!

CincyCat
CincyCat
9 years ago
Reply to  J.D. Roth

Nah – I think you did just fine.

Here’s how I saw your post…

You were explaining basically “Defining Wealth 101” and enhancing it with “102” (Earning), “103” (Spending) and “104” (Saving) information.

Some readers are already way past that, and are wondering why you didn’t present it as a “200” or “300” level by including how investments & compound interest work. I think both of these concepts are important, but they were really out of scope for what you were trying to explain in today’s post.

El Nerdo
El Nerdo
9 years ago
Reply to  J.D. Roth

Owner’s Equity
+Revenues
-Expenses
+Gains
-Losses
+Contributions
-Withdrawals

http://www.quickmba.com/accounting/fin/equation/

I’ve been thinking about it all morning, modern accounting was invented in the XIV century and has had time to get really sophisticated. No need to reinvent gunpowder/the wheel /computers!

I’m seriously thinking about taking an accounting course this summer– for fun (and profit). Can you believe it?

Anyway, if you can translate the principles of financial accounting into simple easy to grasp ideas for personal finance you have an educational gold mine in your hands.

Jaime B
Jaime B
9 years ago
Reply to  J.D. Roth

I think the article was fine, not confusing. However, with an eye to editing, the bit about the equation could have been removed entirely and not affected the content of the article.

Jonathan
Jonathan
9 years ago
Reply to  J.D. Roth

Well, investment returns can all be considered part of “earnings.” And investing, an important skill to wealth-building, can be lumped into the “earning” category.

retirebyforty
retirebyforty
9 years ago

The formula looks very simple, but it is extremely difficult to pull it off in real life. How many of us can excel at all three things? Most people who earn more also spend more. You also need to balance your quality of life too. What’s the point of having so much money if you don’t spend anything. 🙂

Jonathan
Jonathan
9 years ago
Reply to  retirebyforty

retirebyforty, I think your name says it all for some people. I consider myself a disciplined spender (more like I have an aversion to buying things) and a great saver, and I also have a great income for my age. My wife and I today manage to save and invest close to half of our gross pay without living like misers. The goal, though, is to eventually “retire,” by which I mean be freed from the need to go to work each day to support ourselves, and be able to live a great life and give generously.

Pat S.
Pat S.
9 years ago

Sometimes its worth going back to the basics. Great points!

CincyCat
CincyCat
9 years ago

I just read the post about making money from your hobbies, and this is something I’ve been toying with for a while. I sew. A lot. And very well, according to family members (who are unbiased, I’m sure…LOL).

Burnout is cited as the #1 reason people give up on the idea. (What was once a fun activity done in their spare time now had the pressure of clients & deadlines.)

For those of you who have made money at a hobby, how did you avoid burnout?

El Nerdo
El Nerdo
9 years ago
Reply to  CincyCat

Alcohol! 😀

(i kid. spending days doing absolutely nothing helps.)

(also, being organized helps avoid the burnout in the first place)

Catherine
Catherine
9 years ago

Personally I like the term “savings” as opposed to “savings and investments”. Savings has two parts — accumulating the funds and then placing the funds in an array of accounts that balance liquidity and return. For example, I keep six months’ income in a money market account despite its crappy return rate so that I always have access to cash when I need it. This allows me to be more aggressive with my investment portfolio. Investment strategy is but one component of a successful savings plan.

Nate
Nate
9 years ago

I tend to think of savings in terms of liquid monies (bank savings accounts etc.). I think of investing as money with an expectation of profit (i.e. expect the money to grow over time). My FAVORITE is speculation — which promises no safety of the initial investment let alone a return on that investment 🙂 But it can be fun, assuming you have enough saving + investing going on outside of the speculation. Otherwise it sucks.

Wade
Wade
9 years ago

A very good post. I find that once you start learning how to save, it is easy to forget about possible income streams. For example, if you enjoy blogging, try to put up some ads to make a little income from it. It’s just another hobby that can earn a little side money, like my sister enjoying doing crafts and selling them.

Suzanne
Suzanne
9 years ago

The place I focus in this equation of spending and saving etc. is on earning more. If I improve my skills year to year, I have the ability to earn more. If I am still living well within my means then I will save more as I earn more.

Rob
Rob
9 years ago

How about the Sharpe Ratio as an objective measure of savings skill?

Marsha
Marsha
9 years ago

I’m planning to shamelessly steal your three-prong approach when I teach personal finance to young people. The way you presented it makes it easier for me to classify a particular finance topic under one of three headings. I think my students will grasp the concepts better if they are organized in such a manner.

Heidi (at PocketChangeBook)
Heidi (at PocketChangeBook)
9 years ago

I would argue that there are actually FOUR essential components to basic personal finance: earning, spending, saving, and motivation!! How many times do we say, “I know exactly what I’m supposed to do, I just can’t make myself do it?” Many times, it is not a knowledge deficit that gets in our way, it is a MOTIVATION deficit.

Hunter
Hunter
9 years ago

Succinct. Enjoyed this perspective. Thanks.

Cass314
Cass314
9 years ago

This is perhaps a silly question, but how can you be good at earning and keeping costs low, but not saving? Where does the money go, if you’re making it and not spending it? Or are you distinguishing between “saving” it in your checking account and putting it somewhere with some amount of return?

Carl
Carl
9 years ago

Actually I disagree with your equation altogether. We are brought up to follow this equation, but this is why the majority of people struggle through their lives and never achieve the financial dreams and goals they set(or don’t). Either this or they end up lowering their goals and cutting their visions down so that they match their income. True wealth comes from leveraging your time and money to work for you. Its no a simple one minus the other equals what you have. If we teach ourselves to make our money work for us then we will truly become wealthy… Read more »

Will @ HackingTheBank.com
Will @ HackingTheBank.com
9 years ago

I think everyone needs to do some form of tracking of what they spend. If you just set up Mint and watch your money it’s hard not to become a conscious spender.

Gaston
Gaston
9 years ago

I would split the equation in four parts: Earnings – Spending = Savings * investing. Because many people are saving but they aren’t investing. They give their money to people for a little return to other people who are investing and make a lot of money with their savings. Guess who? They multiply your money by ten, twenty and more.

Tom
Tom
9 years ago

People tend to focus too much on the saving side of the equation. The earning side has unlimited potential, but you can only save so much.

Amy Saves
Amy Saves
9 years ago

I’m all about selling stuff I don’t use on ebay or Craigslist. It’s killing 2 birds with one stone. Get rid of clutter and make some money. Also great for when you want to upgrade to something else. Sell the old one first and use the funds towards the new purchase.

Great tips!

AG
AG
9 years ago

I will say this. Personal finance is VERY EASY.

99.9% of personal finance is ARITHMETIC!

However, WE make it very complicated with our own psychology and beliefs.

–AG

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