Tuesday, February 14, 2012

Personal Finance: Money Flow

A recent article at Seeking Alpha by Tim McAleenan made me think critically about how money flows in my life. The issue addressed in the article was whether investors should always reinvest their dividends or use some of that income for discretionary expenses such as concerts and vacations. In other words, to what degree should dividends be used to build future wealth compared with providing immediate (or near-term) gratification?

In the first part of my comment on the article I wrote:
I reinvest all dividends as a matter of discipline, keeping my investments (and the income they produce) "off limits" for financing anything else. I can do this because I have regular income from my job that is more than sufficient to cover my expenses, so I don't need to tap into my dividend income stream at this point in my life. If I want to splurge on a concert, vacation, toy, etc., then I save the money from my job income rather than using dividends.
I wanted to take this opportunity to expand on the second part of my comment, which addressed how I view money flow in my life. The following diagram (click to enlarge it) summarizes my view:


My money resides in two places: my bank account and my brokerage account. My bank account has a single inflow: job income, which is constant from month to month. I need to ensure that I make judicious use of my job income, so it is important to monitor how much of it goes to expenses. The first outflow is money used to pay for necessary expenses, such as rent, utilities, food, etc. It is first because it is essential for my income to cover my basic needs. The second outflow is money used to pay for discretionary expenses, such as concerts, vacations, entertainment, eating out, etc. I have more control over this outflow because I can choose whether I want to spend money on those things (hence the label "discretionary"). If I want immediate gratification, then I can use this money to buy whatever I think will give me it. However, there is a tradeoff: the more money I spend on discretionary expenses, the less money is left over for the third outflow, which is savings for investment. As part of this blog I keep track of my monthly savings.

Savings flow from my bank account into my brokerage account, where I use the money to invest in dividend-growth stocks. An important aspect of my brokerage account is that it has no outflows. Dividends and capital gains from my investments are reinvested, as indicated by the loop in the diagram. As noted on my Strategy page, dividend reinvestment is a key part of my compounding machine for generating a sustainable, rising stream of dividend income. I consider the outflow restriction to be an important aspect of my investing discipline: Money for and from investments is not to be used except for its intended purpose, which is to fund my future retirement. Any money I need to pay current expenses has to come from my bank account.

Of course, circumstances may arise where I suddenly need access to a large sum of money that exceeds my monthly job income. If that happens, then I make use of the Emergency Reserve indicated on the diagram. This is a fair-sized amount of money residing in my bank account that is set aside for emergencies. I can make use of it without having to touch my investments, which again helps to maintain discipline. Notice that its outflow is capped, which means I do not take money out of it unless it is absolutely necessary. Should a situation be so extreme that my Emergency Reserve is insufficient to cover it, only then would I tap my brokerage account.

In summary, I think the diagram provides a fairly accurate interpretation of how money flows in my life. It has a structure that satisfies my current needs and wants, enables saving and investing for the future, and includes a contingency for emergencies. Overall, I think this structure helps me stay disciplined in how I manage my finances.

5 comments:

  1. Nice write up Deedubs. I feel the same way you do about the dividends. They are off limits and accumulating for now. Hopefully I will not need them for years to come.

    ReplyDelete
    Replies
    1. Hi Stoic Investor,

      I am glad to hear that you feel the same way. By putting our dividends to work for us now, we are enabling the money that money makes to make more money (that was a mouthful!), which will compound nicely over time. I think this kind of investing discipline is a key to long-term success.

      Cheers,

      Deedubs

      Delete
  2. Good stuff man. I'm in the same exact position as you. If I was to produce a flow chart, mine would look exactly like yours.

    Sounds like we're both on the same track!

    Best wishes.

    ReplyDelete
    Replies
    1. Hi Dividend Mantra,

      I figured your money flow would be similar to mine. I think this approach will work out well for both of us!

      Cheers,

      Deedubs

      Delete

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