Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Wednesday, July 22, 2015

Advice To My 20-Year Old Self: Form Good Habits

I was asked the following interesting question: "if you could give personal finance advice to your 20-year old self, what would it be?"  My answer is: be aware of your habits, and aim to create good ones.

Habits Matter

One of the most basic questions you face every day: can I afford to buy this item? The item can be as mundane as a cup of coffee, to a new car.

Believe it or not, the dominant school of economics believe that everyone plans out the effect of every transaction on their lifetime economic situation. This means that every time you purchase a cup of coffee when you are 20 years old, you have weighed the trade-off of buying the cup of coffee now versus having the ability to go out for dinner when you are 65. (Yes, that is crazy.)

More realistically, you follow certain patterns, and you decide whether or not you can "afford" that coffee based on those patterns. More generally, following habitual patterns will probably result in your spending on most items to be steady from year-to-year. Therefore, the key to personal finance is having habits that are not self-destructive. For example, if you attempt to follow the consumption patterns of your friends or neighbours who happen to earn considerably more than you do, you would likely end up heavily in debt.

There are times when you need to plan, and not rely on habits. This is typically the case for larger purchases. Should I buy that house, or rent? Buy a new car, a used car, or take the bus? These decisions need to be planned out carefully.

I ran into an example of having to make a fairly complicated situation a week ago. We were planning on purchasing a car within a month or so. However, our old car started making some dubious-sounding grinding noises, and we took the car into the service department of the car dealer. It turned out the rear brakes were not functioning properly. We were forced to choose between putting $700 into the old car in order to buy more time to look at our options, or else buy a new car immediately. This situation is unlikely to repeat, so it is a decision that cannot be determined by a "habit." (Luckily, we had done enough research to decide that the new car was the best option for us. Once you factored in the $700 repair bill that we were able to avoid, the discounts on the used cars of interest to us were not enough to make up for the shorter useful lifetime of a used car.)

Where Do You Need To Go?

The most basic question in setting spending habits, is that you need to know how much you should be saving.

In order to get an idea of what is reasonable, you should probably spend some time playing with a retirement savings calculator, or even just forecasting scenarios within a simple spreadsheet. The results you get will depend on the inputs to your scenarios, which are very hard to forecast (what will investment returns be over 40 years?).

But in general, if you are starting young (in your twenties), reasonable input assumptions will probably tell you:
  • if you save 5% or less of your income, your retirement nest egg at age 65 (or so) will be too small to replace your working income;
  • if you save 40% or more of your income, you may be in a position retire at a fairly early age;
  • for savings rates in between those extremes, the results are very sensitive to the assumptions you use in your scenarios. Since you cannot control things like investment returns, all you can do is monitor how your finances are doing as time passes.
Please note that if you have a low income, government pension plans could replace a good portion of your working age income. Also, if you have a pension plan at work, those contributions would count towards your savings percentage. 

Obviously, a lot can happen over 40 years, so I cannot guarantee any particular outcome. But if you have a middle class income, and are saving very little (without a work pension), you will probably not have a middle class lifestyle. If you want to avoid that outcome (which I assume is why you are reading this), you would need a savings rate of at least 10-15% of your income. Beyond that, you need to decide on the relative attractiveness of financial freedom versus your current spending habits.

Additionally, you probably should target having at least one month's salary in the bank or an investment account that you can tap easily. Remember my $700 brake bill? You need a cash cushion to deal with such outcomes. Until you have such a cushion in place, you are effectively in an emergency situation. (I believe that "Mr. Money Mustache" had a good description of how to approach this emergency, but I could not find the particular post.) You really should clamp down on spending, and not commit yourself to owning a car or house, until you have such a cushion in place.

Where Am I Right Now?

You cannot know how much you can realistically save out your income if you have no idea what your existing habits are. It is easy to keep track of some expenses, such as monthly rent, but much harder to track everything else. If you think you are spending $2000 per month, and you are really spending $4000, you are not going to be able make a realistic saving plan.

Although it is probably not an exciting thing to do, you need to sit down and track your spending over a period of time, such as a few months or a year. I do this by downloading my bank statements into a spreadsheet, but there are applications that will do this for you automatically. This form of tracking will not break down how you spend cash (for those of us who still use cash), but it should cover most of your spending.

If you find that you are already hitting your savings target, congratulations! You could pretty much stop reading now. Otherwise, you need to think about how to change your habits to hit the target.

Strategies To Save

In the classic book, The Millionaire Next Door, Thomas J. Stanley discussed the results of his analysis of the habits of the wealthy. He found that although there were a lot of people with high incomes, high incomes did not necessarily translate into high wealth. Wealth was only built up by those who saved. (Another piece of advice: read that book.)

Those with high savings generally used one of the two techniques:
  1. Budgeting: setting limits for each category of spending, and track to make sure that those limits are not breached. You can afford something if there is room in that budget category for the spending.
  2. Pay yourself first. Take a fixed amount of savings each pay period, and put them into investment accounts. In Canada, you may be able to arrange to have the money go directly from your paycheque to your RRSP (a savings vehicle with tax advantages), and get the tax advantage immediately. You are then free to spend what is left over as you wish. You can "afford" something if you have the cash in your account to pay for it.
In both cases, the only borrowing you undertake are for long-term purchases: a mortgage for a house, or possibly car financing and student loans. If you have a credit card, the assumption is that you pay it off at the end of the month. In other words, you have to act that you cannot afford to have debt, unless you are getting something that you really need (a house, car, or education). This advice would probably strike most people as being wildly unrealistic, but it was what everyone believed when I was growing up in the 1970s and 1980s.

You set the numbers you use for these techniques based on the spending audit I described in the previous section. (This is an obvious necessity if you are budgeting.) If you are spending 80% of your income on fixed bills (rent, phone plans, car payments), it would be obviously disastrous to switch over saving 40% of your salary using a "pay yourself first" method; you would need to immediately raid your savings to pay your bills. If you need to save more, you need to figure out how to reduce your fixed bills first. Ideally, you start the "pay yourself first" saving before you start committing yourself to fixed expenses.

The best option seems to depend on your personality type. Thomas Stanley's experience was that the people who had success with budgeting was quite often those who ran small businesses and were well acquainted for having run the firm's budget.

I would generally suggest a variation of the "pay yourself first" habit: "pay yourself an allowance." It's very similar, but rather than targeting saving a fixed amount every pay period, I would instead target allowing yourself to spend a certain amount (everything else is moved to an investment account). The difference between the two is subtle, but important. For example, if you get a raise or bonus, the extra money ends up being saved, not spent. Additionally, you change your thinking from having to spend a certain percentage of your income "to be happy", you think about how much you need to spend.

My Advice In Concrete Steps

My advice about good habits can be turned into the following concrete steps:
  • Track your spending (in as much detail as is reasonable) over at least a few months.
  • If you do not have an emergency cash cushion, clamp down on spending until you have one in place.
  • Do not use credit to pay for "non-essential" expenses.
  • Look at retirement planning tools, to get an idea of what savings rates you probably should be targeting.
  • Decide whether you want to achieve your savings by budgeting, or paying yourself first.
  • Follow the option that you chose in the previous step. You will need to periodically see if you are doing so effectively.

As For My Younger Self

During the first half of my life as a twenty year old, I was a graduate student living off a fixed scholarship. My room and board was covered by a fixed charge at the beginning of the term, and I then had a small fixed amount to cover my optional spending during the term. I had no choice but to live off an "allowance," particularly since no one at that time would lend to graduate students (other than limited government loans).

It was only when I got a job (in my late twenties) that the question of how I could change my spending habits came up. Although it was fun to have more money to work with, it was unclear how I should manage my finances. Over time, I ended up going back to living on an allowance. Since I was just reverting to habits I developed in grad school, this was actually not too difficult. For anyone without such practice, they key seems to be able to develop the ability to create a mental wall between the amount of money you earn (and can borrow) and the amount of money you allow yourself to spend.


  • In terms of understanding the "pay yourself first" concept, I recommend either The Millionaire Next Door, or The Millionaire Barber  by David Chilton.
  • I am able to use the information available at my bank web site, as my investments and bank accounts are available through the same interface. How much you can do will depend upon the capabilities of your bank's web site; the big Canadian banks all seem to have fairly well developed interfaces. I am fairly comfortable downloading my raw transaction data and analysing them in a spreadsheet, a task which may not appeal to everyone. Since I find that is only necessary to do a spending breakdown only about once a year or so, I did not see a need to automate the analysis further.
  • If you do not want to work with spreadsheets, there are a number of tools available for tracking spending and net worth. I have not used such tools, and so I cannot offer a strong recommendation. Some are software packages into which you download financial data, others are online. There are a number of tools available for tracking money in the U.S., such as this tool to calculate net worth. Canadians such as myself could not make use of their services, but there are companies that cover Canada, such as
  • It is very useful to understand how people can shape their habits; if you assume that your habits are "natural," you face the risk that your habits will be shaped by advertising agencies (who do not worry about the state of your personal finances). This is known as hedonic adaptation by researchers; Mr, Money Mustache has one of the better non-technical explanations of the phenomenon that I have come across
(c) Brian Romanchuk 2014


  1. Excellent advice, and very clearly presented. Thanks!

  2. Good stuff Brian. Strongly agree with the points and the importance of saving.


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