Two Approaches to Saving
Here I will introduce you to two ways of approaching your savings plan. I have called them the top-down approach and the bottom-up approach. As their names indicate these are two opposing ways of deciding how to save money each month. For most savers they probably choose a combination of the two methods.
The Top-down Method
This is sometimes called the “pay yourself first” method. Pay yourself first refers to the idea of taking out your set monthly savings target (e.g. 15% of your net salary) before spending any money. To achieve this some savers set up automatic transfers from their bank accounts to their savings account or investment account each month. This way the savings are treated in the same way that a utility bill or rental payment would be treated insofar that the saver then survives on what remains in their account each month.
You can take this method a step further by not only having a set budget for savings each month but also have set budgets for other areas of spending. The ultimate to-down approach would account for 100% of your net income. If you recall in the previous post I did this with my income:
35% Saving
30% Spending
25% Accommodation
10% Welfare
As you can see this accounts for 100% of my net income each month. Obviously the figures will vary from person to person depending on your individual circumstances (e.g. single, married, DINK, etc) and your level of income (a higher income should afford a higher savings rate).
Obviously spending will vary from month to month. There are two ways to deal with this. The first is to simply transfer any excess money to your savings account. So for instance if you only spend 28% one month the extra 2% could be added to your savings to make 37% savings that month. Or the second method, which I prefer, is to keep track of the balances of each pot each month. So for instance if you spend 28% one month and then spend 31% the next you still have an excess of 1% in the spending pot. This method can work well if you occasionally overspend some months but want to keep on track. It also gives you an incentive to under-spend if you are trying to save for something or earn more as this would increase your spending budget.
Of course the proportions of each pot can vary over time. When I first began my saving pot was 15% of my net income, last year my spending was 35%. As you become comfortable at a certain level periodically move the budgets to try and increase your saving budget. Hopefully I can increase my saving budget to 40% of net income soon.
The Bottom-up Method
Whereas the top-down approach sets budgets and then you live within the parameters of these the bottom-up approach starts at the bottom and looks at your spending first. To start with this method you need to monitor your spending, preferably for a month, to gather data for your savings plan.
By doing this you will notice trends in your spending and hopefully identify some areas where you are over-spending or wasting money and cut back in these areas. Over the long run you can also monitor your spending and set targets, for example reduce monthly spending by 10% over the next 3 months. Reductions in your spending rate can then be ploughed into your savings pot each month.
The bottom-up method is probably the most common method for beginners, especially people who may have only a vague idea of their spending patterns and end each month wondering where all their money went.
In reality you will probably use a combination of the two methods to begin your savings journey. With the top-down method your saving is set to your income and it’s simple once you set it up. It can involve some monitoring if you decide to make it more complex and monitor the spending in each pot. The bottom-up method can be more efficient as it is based on your actual spending patterns. It does require continual monitoring of your spending but for many people this works as an incentive to spend less and save more.