Start with recurring monthly expenses
I tend to divide spending up into four categories. From best to worst they are: investments, items of enduring value, ephemeral items, and recurring monthly expenses.
Investments include not only stocks and bonds and such, but also anything that can help you earn money. Tools are investments, as are a classes. I just bought two books that I'm reading before a possible job interview--they're an investment. Some investments may not pay off, but even unsuccessful investments are still investments.
Items of enduring value are anything that you're not going to have to replace anytime soon. This is kind of a sliding scale. I bought my bicycle in 1984 and it's still in nearly perfect condition--definitely an enduring value. My iPod I bought in 2005 and it's still got a couple years of use, I hope, so it's somewhat enduring. Clothes and shoes are not necessarily enduring, but can be. All these items raise your standard of living for as long as they last.
Ephemeral items last only briefly: a movie, a restaurant meal, a hotel room. They also raise your standard of living as long as they last, but they last such a short time it hardly counts. These tend not to be budget killers, except when they're purchased over and over again. If they do, then they belong in the next category.
Recurring monthly expenses are the worst. I'm always cautious about adding a new recurring monthly expense to my budget.
Most books and articles on personal finance exhort you to make cuts in the budget for ephemeral items first, because that's the easiest place to find something you can cut right away. They're wrong, though: Start with the recurring monthly expenses.
To be fair, the books are only half wrong. They talk about ephemeral items, but they always seem to use a latte as their example, pointing out that omitting one latte a day can save you dozens of dollars a month and hundreds of dollars a year. They often calculate the potential return if you invested that money for a few years. (Three dollars a day invested in an S&P index fund that returns 10% over 5 years will be worth $7102!)
The thing is, if you're buying a latte every day, it's not really an ephemeral expense; it's another recurring expense. And, as I said, that's the place to start.
Since recurring monthly expenses (an apartment lease, a cell phone contract, a fitness center membership, etc.) are often locked in for months or years at a time, it's hard to make quick progress reducing them. But that just makes starting as soon as possible--before you lock in another year or two--all the more important. The payoff in reducing recurring monthly expenses is huge. (Just like with the latte, only with bigger dollar amounts.)
I give any potential new recurring monthly expense a hard look:
- If I've done without it for this long, I probably don't need it. There are plenty of things other people pay for every month that I just do without.
- I look long and hard for an alternative that doesn't involve a recurring monthly expense. Maybe you can buy a pair of good scissors and a book on cutting your own hair--a one-time investment instead of a recurring expense. Maybe you can find a hairstyle that grows out well and get your hair cut much less often.
- If there is no such alternative, I do some careful research into whatever it is, trying to find the sweet spot where I get the best value at the lowest price. Some people find looking for bargains rewarding (beyond the money saved itself). I generally don't, so I don't spend a lot of time and effort bargain hunting--except for recurring monthly expenses.
I do the same thing for existing monthly expenses (although step 1 is harder: if it's something I've grown accustomed to, it can be tough to cut).
I don't put nearly the same level of effort into the ephemeral expenses. For example, I generally don't bother to look around for deals on these items. I pay attention to what a restaurant meal costs, but I'm really more interested in whether I like the food. The key with ephemeral items is to keep the quantity under control, not to find the best deal.
With enduring items, I focus on quality. Something might well be worth more if it'll either serve its function better or last longer.
Analyzing investments is worth a post all its own, but it's all about risk, reward, and liquidity.
Start with the recurring monthly expenses. That's where the money is.