Here’s How To Build a Better Personal Budget

Traditional financial advice often emphasizes setting realistic or conservative budgets. However, our 2023 study suggests otherwise. We analyzed more than 350 million transactions from 70,000 users of a United Kingdom personal finance app and made a startling discovery: Setting optimistic budgets led to a 21.9% reduction in spending compared to not budgeting at all.

Surprisingly, this effect persisted even when people didn’t strictly adhere to their budgets. The influence of these optimistic budgets on spending was still evident six months later, despite people’s imperfect budgeting.

Consider Audrey, who typically spends $300 monthly on groceries. Instead of setting a “realistic” budget of $280, she might set an optimistic target of $240. Even if she ends up spending $260, she’s still saved more than if she’d set a conservative budget, or no budget at all.

‘Atypical’ Expenses

Our second key finding addresses another aspect of financial management: predicting future expenses. We found that a simple mental exercise – considering why your expenses might be different one month – can dramatically improve expense prediction accuracy.

In a series of studies involving more than 6,000 participants, we discovered that prompting people to think about atypical expenses reduced the errors they made in predicting their spending by an average of 40%. This approach helps bring to mind often-overlooked costs, leading to more realistic financial forecasts.

Imagine Paul, planning his monthly budget. He easily recalls regular costs like rent and utilities. But by considering atypical expenses, he remembers his car needs a (safety inspection) this month and his sister’s birthday is coming up. This more comprehensive view leads to a more accurate financial plan.

Interestingly, our research suggests that optimistic budgets and realistic predictions serve different purposes. Optimistic budgets are most effective for reducing day-to-day discretionary spending. They act as a motivational tool, nudging you to cut back on small, frequent expenses.

On the other hand, realistic predictions are crucial for major financial decisions. Consider Theo, who wants to buy a house. To determine how much he can afford in monthly mortgage payments, he needs to predict his total monthly spending on other expenses.

By considering atypical expenses, he can make a realistic prediction and avoid taking on a larger mortgage than he can comfortably afford. The same principle applies to other significant purchases, like cars or appliances.

Here’s how you can apply these insights:

1. For daily expenses, set ambitious budgets: Aim about 20-25% lower than your typical spending.
2. For major financial decisions, make realistic predictions. Consider atypical expenses to get a comprehensive view.
3. Write down your optimistic budget and keep it visible.
4. Don’t give up if you overspend. Use it as a learning experience.
5. Before making financial plans, take five minutes to brainstorm potential unusual costs.
6. Review your atypical expense list monthly and update as needed.

There’s psychology behind these strategies. The effectiveness of optimistic budgets relates to the concept of reference points in behavioral economics. Even if we don’t hit the exact target, having an ambitious goal influences our decisions, nudging us towards lower spending.