How To Budget – The 3 Account Method

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One of the essential principles of financial management whether you are a huge multinational corporation, a government organization, or an individual, is always being sure to match your assets to your liabilities using a budget.

As a quick refresher for those not familiar with accounting jargon: assets are things of value that you have in your possession (cash, shares of stock or units in a fund, property, or even intangible things like patents or copyrights), and liabilities are any kind of financial obligation (whether it be for example a formal liability like a debt to a bank, or even an individual just knowing that “exactly 12 months from now I’m flying my whole family to visit the in-laws and I’m going to need at least $7,000”.)

Basic Budgeting – How To Match Assets to Liabilities

By “matching” our assets to our liabilities, we simply mean sitting down and reviewing all short term liabilities, medium term liabilities, and long term liabilities; and then making sure we make arrangements for these financial obligations or debts to be covered by the proper short term assets, medium term assets, and long term assets.

One of the main reasons that people experience such trouble with their finances is that they fail to match their assets to their liabilities. This can be fixed with a simple budget. All too often individuals take on too much risk by matching an intrinsically long term asset to meet a short or medium term liability; or, on the other hand, they expect short term assets to take care of short, medium, and long term liabilities.

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Now of course no two people are exactly the same.  Everyone has their own unique background, existing resources, and personal aspirations for the future.  However, in most cases, if an individual can successfully maintain three main types of accounts (short, medium, and long-term), they can effectively manage their short, medium and long term liabilities.

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The Short Term Account

The short term account is the easiest, as we are all likely already familiar with it.  This is the primary bank account that manages the month-to-month expenses and bills, and is most likely where our salary is paid. The short term account should also be used to budget for and accumulate savings for any big near-term expenses (ie. within 1 or 2 years), and as such in “matching” our assets to our liabilities, the only investments we should have in here are short fixed-term bank deposits (eg. six months to one year).

Saving money

For example, the person above saving for the $7,000 trip one year from now can section off the necessary savings in a 1 year fixed term deposit. If for example the bank is offering 2.5% on 1-year deposits, he simply puts away $6,829 (as 6,829 * 1.025 = 7,000).

Not exactly creating millions in wealth, but it is certainly an easy $171 in return for about 5 minutes of proper planning and foresight.  And it helps lock away the money to keep us from “accidentally” spending our savings when we know we shouldn’t.

The Emergency Fund

Lastly, another core aspect of the short term account will be the “emergency fund”.  Usually equal to somewhere between 3-6 months living expenses, this is an amount that should be kept in liquid cash to support yourself in the event of an emergency like a sudden loss of job, having to move, family emergencies, etc.

The Medium Term Account

Once we have accumulated the “emergency fund”, and short term liabilities have been matched with short term assets, we can start thinking about the medium and long term.

The medium-term account can be best thought of as the “discretionary fund” to be used in planning for large medium-term financial obligations happening usually in 5 to 10 years (examples being a down payment on a home, starting a business, big university fees, etc.).

The reason this is referred to as the “discretionary fund”, is because this is where people will tend to find the most variation between themselves.  Our own personal 5 and 10 year plans are very much a part of who we are and how we define ourselves. As such, the proper medium term investment will need to be just as fitting to our personal preferences and everybody’s budget will be different.

In order for these dreams to come to fruition, we must ensure that we select the correct level of risk and reward to fit the financial obligations of our medium term goals.

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The Long Term Account

Last come the long term assets.  Interestingly enough, these can be the most difficult if only because they are the most simple.

Long term assets are to be used for our long term goals (usually spanning 20-30 years in the future), and are often referred to as “capital accumulation” accounts.  Because it spans such a long period of time, discipline and overall strategy for the investments tend to vastly outweigh any kind of micro-managing of the account.

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Our long-term financial obligations can also be quite intimidating (as things like supporting ourselves in old age are not cheap…), so it is imperative that we develop strategies that allow us to begin accumulating these long-term assets, ensure that the assets achieve long-term and steady growth, and most importantly that we give ourselves dis-incentives to access the account.

Over the course of 20-30 years every 6 months or so there will always seem to be some immediate “justifiable” reason to “take a break” from saving.  Also every 2 to 3 years, like clockwork, some major event will occur in our lives that necessitates withdrawing large chunks from our long-term savings which will jeapordise our long-term budget.

Both of these issues severely de-rail any plan or ability to accumulate wealth in our long-term account. Instead, utilizing a strategy with the three accounts will enable you to absorb the short-term and medium-term costs and liabilities as they arise, keeping our long-term nest egg safe and growing.

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Sources and Further Reading