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DMFS Financial Advisers is a financial planning practice focusing on retirement planning, wealth accumulation and aged care.

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Budget strategy and cashflow

20 March 2016

Establishing and sticking to a budget can be extremely difficult given the convenience of modern electronic payment methods and readily available credit.

Advertising encourages us to buy now and pay later and it can often be difficult to determine if you can afford to make a given purchase when factoring in interest free terms, or even variable income from pay to pay.

The most important step in clarifying your cashflow position is the preparation of a detailed budget which accurately identifies what you are spending compared to what you are earning.

Structuring your budget

Your budget will have a portion of ‘fixed’ expenses. These are committed expenses such as loan repayments or council rates.

A portion of your budget will be ‘variable’ in nature. Review these variable expenses as this is an area where you may be able to make some savings.

The key to establishing a structured budget is to relate your total annual expenditure to a pay period and immediately set aside a portion of each pay for the purpose of paying bills and meeting your debt repayment and savings goals. For example, if your total annual bills amount to $12,000 and you are paid monthly, you could set aside $1,000 per pay for the sole purpose of paying these bills and you would always have sufficient funds available to pay bills as they arise.

The remaining portion of each pay, after allowing for an amount for bills, debt repayment and personal savings, may be directed into your working account for discretionary spending purposes.

This concept is demonstrated in the following diagram:

Structuring your budget diagram

It is important to review your budget regularly for the following:

  • Your net income (your after-tax income from all sources).
  • Your commitments/bills (ongoing expenses such as phone bills, rates, registration, loan payments, groceries and all other expenses identified in your budget).
  • Your regular savings (funds which must be set aside on a regular basis to meet goals such as holidays, additional loan repayments or saving a portion of your income).

As your income and expenses change, regularly review your budget to ensure that you are effectively using your income and reducing expenses where possible.

Bank account restructure

Even with the best of intentions, it can often be difficult to stick to a budget.

Many people have several accounts at banks and credit unions but find it difficult to use these accounts effectively. Most end up using the account that their pay goes into for everything, paying bills, drawing living expenses and meeting fixed commitments. This makes it very difficult to stick to a budget as you can’t really track what has been spent and if in fact you are overspending in some areas.

While the concept of diverting your salary into various accounts and vehicles sounds relatively simple, most people find that unless the correct structure has been initially established, there can be some confusion as to what monies are to be used to meet living expenses, as opposed to those funds set aside for savings and wealth creation.

Give consideration to restructuring your existing accounts to include (at least) the following three types of bank account:

  • A ‘Hub’ account (to use as the core of your budgeting strategy and to receive all income).
  • A ‘Working’ account (an easily accessible account used for discretionary spending).
  • A ‘Savings’ account (to receive regular savings and paying a suitable rate of return).

The following diagram outlines this general approach:

Bank account restructure diagram

The type of account suitable to serve as a ‘Hub’, will provide an acceptable rate of return on funds retained within and provide a flexible, cost effective means of transferring funds using internet banking.

An account suited to function as your ‘Working’ account should offer flexible and immediate access to your funds whilst a higher rate of return will be of importance for a ‘Savings’ account.

When restructuring your accounts, give consideration to:

  • always having sufficient funds set aside for expenses, billsand discretionary spending.
  • ensuring that funds retained in a ‘Hub’ account for bills earn a high rate of interest.
  • implementing a cashflow strategy which clearly defines which income can be used for which purpose, therefore enabling you to live within your means.

Most importantly of all, you will be rewarded for introducing a disciplined budget by eventually achieving your savings goals, reducing stress relating to bill payment and gain peace of mind in the knowledge that you are using your income as effectively as possible.

Dollar cost averaging explained

20 March 2016

Dollar cost averaging is simply the term used to describe the strategy of making regular incremental investments over a period of time as opposed to a one-off lump sum investment.

The theory behind this strategy is that you can reduce the market timing risk of investing your entire portfolio in a single transaction on what might be an expensive entry point. In other words, if you invest a lump sum on a day when the market is up you will purchase a lower number of units compared to a day when the market is lower. By adopting a dollar cost averaging strategy you can spread out your investment entry points and potentially achieve a lower average cost base, which means you purchase a greater number of units for the same (investment) amount.

Dollar cost averaging is most effective when markets are on a downward trend. In a rising, or bull, market environment, a dollar cost averaging strategy is not as effective; obviously the lump sum investment would be optimal on the day when the price was lowest – the fundamental principle of buy low, sell high… but how do you know when that day is?

Effectively, all working Australians practice a dollar cost averaging strategy within their superannuation accounts. For most of us, each month, our employers contribute 9.5 per cent of our salary to superannuation. The decision to actively choose to implement a dollar cost averaging strategy arises for investors who need to restructure investments to manage a new stage of life or perhaps due to an abnormal receipt of funds such as an inheritance.

The success of a dollar cost averaging strategy will depend upon the future returns from the investment.

Case study

Let’s look at a simple example of dollar cost averaging in action. The table below shows how someone who invests $200 every month for five months will pay different amounts for each unit as the market price changes. Over the whole period of five months the average cost per unit was $7.37 so not the lowest or the highest price that the units cost during that time. Dollar cost averaging helps reduce the risk that the timing of a purchase coincides with the price being particularly high. The table also shows the best and worst cases achieved if the total purchase was made all at one time instead of being spread out:

Month Investment ($) Unit price ($) Units purchased
Month 1 $200.00 5.00 40
Month 2 $200.00 6.67 30
Month 3 $200.00 10.00 20
Month 4 $200.00 6.67 30
Month 5 $200.00 8.50 24
Average purchase price = 7.37 144
Dollar cost averaging strategy Total cost of investment $1,000.00
Value at end of period $1,220.00
Profit $220.00
Worst timing of purchase (Month 3) Total cost of investment $1,000.00
Units @ month 3 $100.00
Value at end of period $850.00
Loss -$(150.00)
Best timing of purchase (Month 1) Total cost of investment $1,000.00
Units @ month 1 $200.00
Value at end of period $1700.00
Profit $700.00

Unit Pricing Example

Unit Pricing Example diagram

In summary, a dollar cost averaging strategy can be an effective way to invest over the long term, however, there are market environments which would better suit lump sum investing.

For a long term investor, the decision should be about time in the market not timing the market. Perhaps the decision to invest a lump sum over a longer period of time should be based on your appetite for risk. If you can tolerate short term price volatility in favor of longer term gains, you may consider making lump sum investments during low entry points. Many investors, however, remain cautious on short term price volatility regardless of the long term investment horizon and gain more comfort from slowly deploying funds into the market to average out the entry point. The secret to successful investing is time in the market, rather than timing the market.

contact

Level 8, 350 Collins Street

Melbourne VIC 3000

1300 364 650
(03) 8672 0287
david@dmfsfinancial.com.au