Imagine staring at your bank statement, wondering how you've overspent again. You've tried budgeting apps, spreadsheets, the envelope system and even zero-based budgeting, but nothing sticks. Sounds familiar? If so, you're not alone - and surprisingly, the solution might be to loosen up your financial planning rather than tighten it.
Authors
Marcel Lukas
Senior Lecturer in Banking and Finance and Director of Executive Education, University of St Andrews
Ray Charles "Chuck" Howard
Associate Professor of Business Administration, University of Virginia
Our research challenges conventional wisdom about personal finance, offering insights that could revolutionise how you manage your money. Two key strategies emerge: setting optimistic (that is, stricter) budgets and considering atypical expenses. While these might seem counter-intuitive, the evidence suggests they could significantly improve your financial health.
Traditional financial advice often emphasises setting realistic or conservative budgets. However, our 2023 study suggests otherwise. We analysed more than 350 million transactions from 70,000 users of a UK 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 an MOT 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:
For daily expenses, set ambitious budgets: aim about 20-25% lower than your typical spending
For major financial decisions, make realistic predictions. Consider atypical expenses to get a comprehensive view
Write down your optimistic budget and keep it visible
Don't give up if you overspend - use it as a learning experience
Before making financial plans, take five minutes to brainstorm potential unusual costs
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 behavioural economics. Even if we don't hit the exact target, having an ambitious goal influences our decisions, nudging us towards lower spending.
The success of considering atypical expenses is rooted in "cognitive accessibility", which just means how easy it is to recall a certain fact (or, in this case, amount). By deliberately bringing less common expenses to mind, we create a more comprehensive mental picture of our financial landscape.
These findings challenge long-held beliefs about personal finance. Some might argue that optimistic budgets set people up for failure. However, our research suggests that the motivational benefits outweigh the potential downsides of missed targets.
Similarly, some might worry that considering atypical expenses could lead to overly conservative planning. Yet, our studies show that this approach leads to more accurate, and not overly cautious, predictions.
These findings have implications beyond personal finance. Financial education programmes could incorporate these strategies into their curricula. Budgeting apps might be redesigned to encourage slightly more optimistic targets for daily spending and prompts for considering atypical expenses when making major financial decisions.
As we navigate uncertain economic times, tools for effective financial management are more valuable than ever. While these strategies aren't a magic solution to all financial woes, they offer evidence-based approaches that can help people gain better control over their finances.
Managing your money effectively doesn't always mean following conventional wisdom. By strategically using optimistic budgets and realistic predictions, you might find yourself with a more robust and effective financial strategy. In the complex world of personal finance, sometimes the most powerful tools are also the most surprising.
Marcel Lukas receives funding from The British Academy. Marcel Lukas is a Fellow of the Office for National Statistics and a Trustee of the Centre for Financial Capabilities.
Ray Charles "Chuck" Howard received research funding for some of the studies mentioned in this article from the Social Sciences and Humanities Research Council of Canada, and he is currently an advisory board member for the Financial Consumer Agency of Canada.
