The "one big lump" theory of your money

by Philip Brewer on 3 January 2009 10 comments
Photo: Philip Brewer

Don't get confused by the way your money's divided up.  It might be split up into IRAs, 401(k)s, 403(b)s, 529 plans, and annuities.  Separately from that, it might be invested in different things--stocks, bonds, real estate, and cash.  You might even use separate accounts to segregate your funds by goal--emergency fund, retirement savings, car down payment, and sending the kids to college.  Despite all that, it's really one big lump of money.

All those things--compartments, investments, accounts--are tools. And it makes no more sense to treat your money as different because of the compartment it's in than it would to divide up your garden produce based on whether the plants were weeded with a hoe or a trowel.

Come to think of it, groceries make a pretty good metaphor. You divide your food up into categories several different ways--whether it needs to be refrigerated or not, whether it's home-grown or not, where it fits into the food pyramid (or four food groups, if you're old). But your goal is a healthful diet for your family, and you meet that goal with the smaller goals of a series of good meals. Your entire pantry is at your disposal to serve those goals, and you'd never assume that you can only make breakfast with foods in the refrigerator, while making dinner with only canned food.

When it comes to their money, though, people start thinking like that. They assume that the money in their retirement account has to be invested for their retirement. They mentally allocate specific investments to specific goals--so if the stock market goes one way they get a great vacation but can't afford to repave the driveway (or vice versa).

Don't do that. Instead, treat your money as one big lump that supports all your goals. Then, use the various compartments and investments and accounts as tools to help you use your one big lump of money to satisfy all your needs--and as many of your important wants as possible.

Let me pause here for a moment to say that I certainly understand the temptation to target some funds--I used to do that. I'd figure, if I just put $x out of each paycheck into some account, after so many months I'd have enough money to buy some thing or another. I used to wish for a facility that didn't exist then, but actually does now:  sub-accounts. At most of the internet banks and brokerage firms, you can divide your account into sub-accounts targeted for some specific goal. Then, when you make a deposit, you can allocate the money among any or all of those sub-accounts.

It's really all in one account; they're just keeping track of a variety of subtotals for you. And that's one clue as to why it's better to treat your money as one big lump--because it really is.

There are several wins if you treat your money as one big lump.

Double-counting

One advantage is that some of your money can serve several purposes at once. This is most obviously true for cash.

You need cash for several purposes. You need cash for liquidity--to smooth out the fact that the dates that your bills are due on are not synchronized with the dates you get paid. You need cash for emergencies--because a certain category of problem can only be solved with ready cash that you can spend today. You also want to have cash on hand to take advantage of opportunities--tomato paste going on sale is not an emergency, but there are huge investment returns (tax free!) if you stock up when you see a great deal. You also sometimes need to accumulate a large sum of cash for large transactions like a car purchase or a real estate closing.

To a considerable extent, you can use one pool of cash to support all these purposes. The money you keep on hand for liquidity is part of your emergency fund. You don't want to tie up a large fraction of your emergency fund in "opportunities," but you can invest several percent of it in household staples without putting your finances at risk (in fact, for a certain category of emergencies, such as a flood or a blizzard, a few jars of peanut butter and a big bag of rice is a lot more useful than cash in an internet savings account).

The same is true of all the other categories of investments in your portfolio. All your stock investments support all your long-term goals. All your bond investments support all your medium-term goals. And so on.

Clear thinking

Another big advantage to treating your money as one big lump is that it's a more accurate model of reality.

If you're one of the people who puts a few dollars every paycheck into several different accounts, each saving up for some particular goal, what happens if there's an emergency? You've got two choices: You either cover your emergency with credit (and pay interest), or else you raid your special purpose accounts for the cash (and feel bad).

You have the same two choices if you treat your money as one big lump--except that you can skip the feeling bad part, because you never pretended that the money was "allocated" to some goal or another. It was all part of your one big lump of money that supports all your goals--including dealing with an emergency.

Divided the money up by goal is one of those little tricks people use to fool themselves into doing the saving that they want to do, to keep themselves from just spending it on passing whims. Although I'm generally in favor of whatever tricks people find that seem to work for them, I think this one should be avoided.

See, what you're doing is lying to yourself. If you're only lying to yourself about the little things--pretending you only have the money in your checking account to get by until payday--that's fine. But your entire portfolio is too important for you to be managing it with one eye closed, pretending that it's something other than what it is.

Unified perspective

If you've got a plan for satisfying your wants, you've already got all the advantages of pre-allocating the money, without the disadvantages of lying to yourself.

Just like the person who puts money into a bunch of separate accounts, figure out how much you need to save to fund all your various goals--and then save that much. But instead of dividing the money into separate accounts based on goal, feed it all into your one big lump of money--and then manage that one big lump of money as a unified portfolio that supports all your goals.

Optimize compartment advantages

Finally, once you're managing your money as one big lump, you're in a much better position to take maximum advantage of things like tax-advantaged accounts such as IRAs and 401(k)s.

See, income earned in those accounts accumulates tax-free, but any money that you take out of those accounts is taxed as income--including capital gains that would otherwise have been taxed at a favored rate. So, the key to take advantage is to use those compartments to hold income-earning securities. Don't fund your IRA or 401(k) with long-term investments for your retirement! Fund your IRA or 401(k) with things that earn interest. (I wrote about this in more detail in Your 401(k) is not an investment.)

If you think that your 401(k) or IRA needs to have a balanced retirement portfolio, you're going to miss out on some of the juicy tax advantages that the plans offer. The key to avoiding that misstep is to understand that your whole portfolio is one big lump of your money. No individual account or compartment needs to be balanced on its own--it's only your entire portfolio that needs to be balanced.

And the way to keep that perspective is to treat your money as one big lump that supports all your goals.
 

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Guest's picture
Jared

I think it's much easier for some people to compartmentalize their money into different places because many people don't have the self-discipline to lump all of their money in one place. Like if you have a wad of money in your pocket, we all know what's going to happen to it. But if you have some in your pocket and some buried in the yard, you won't spend the buried money very easily.

Making your money hard to get to is essential for some, only if they don't have the self-discipline.

Philip Brewer's picture

Obviously a lot of people think that they need to keep the money compartmentalized.  That's why I felt moved to talk about it--because I don't think they realize the trade-off they're making.  You lose a lot of power and flexibility in money management if you rely on compartments rather than viewing your portfolio as a whole.

Tucking the money away somewhere so that it's hard to spend is a crutch.  A crutch is fine for the short term, but in the long run you want to develop the capacity to stand on your own if you possibly can.

Follow the example of the toddler, who learns to walk by holding onto a parent's hand and leaning on the furniture.  Yes, some people need a cane, but nobody goes out and buys a cane for a toddler just because he's fallen a few times. 

I take the same view of money management.  Develop the capacity to manage your portfolio as a whole.  It's so powerful even if you make a few mistakes along the way you'll still come out ahead.  (As long as you don't use it as an excuse to keep making the same mistakes over and over again.)

Guest's picture
Guest

Nah. I disagree completely.

Guest's picture
Ken

I agree. All the goals and expenses add up to, in your words, one lump sum. As the first comment noted though, thinking about it this way does require self discipline. If your "lump sum" isn't going to be big enough, which category(ies) get cut first?

Cheers,
Ken

Guest's picture
Guest

Overall I enjoyed the story and agree with most of it. The double-counting cash management idea just sounds like trouble waiting to happen to me. As my parents taught me when I was a child, "you can't spend it twice". As other posts mention, with self-discipline this doesn't have to be a big problem. But what about when your spouse has access to the account? You're planning on using that cash for bills, while they're off grocery shopping and happen to find the tomato paste bonanza - not knowing that an opportunity expenditure will cut the checking account low enough to trigger an overdraft charge? I'm not talking about anything malicious. Just not enough communication. It's an easy mistake. And if the emergency fund is lumped in as mentioned there may not be an overdraft fee involved, but I'd be more worried about dipping the emergency cash too low. Especially if it's so readily accessible and being tapped into in such an innocent way. It could erode away faster than I'm comfortable with. Identity theft, debit card # stolen, you name it... I don't want something like that to make my emergency funds evaporate - even if it does come back in a few months after the bank sorts things out.

I guess for me it comes down to "one big lump, except a few specific things".

Philip Brewer's picture

Right!  Multiple accounts serve many useful purposes:

  1. Protecting your cash from accidents (due to miscommunication or carelessness) and from crimes (like identity theft). 
  2. Access to different ranges of investment choices. 
  3. Protection against temporary hiccups caused by things like a natural disaster (that might keep workers at the instituion from getting to the oiffice--or keep you from getting to your local bank) or any kind of problem that might shut down their computer or telecommunication systems.

In addition, the different kinds of compartments (like IRAs and 401(k)s) offer some protection if you're sued or forced into bankruptcy. 

And that's my whole point.  When you manage your money as one big lump, you can make a plan for splitting your money up into multiple accounts based on maximizing these sorts of advantages.  That gets a lot harder if you're simultaneously trying to keep the money for your back-to-school wardrobe in one account and the money for the kid's braces in another account.

Guest's picture
Slinky

p: Your checking account contains money you will spend soon.
q: Soon you will spend money on X, Y, and Z.
r: The money in your checking account is for X, Y, and Z.

p ^ q -> r

Seems like a fairly accurate model of reality to me...

This seems like the argument on joint vs. separate checking accounts for married couples to me. Look at it upside down, inside out or any other way you want, you still end up with your money in the same places.

Philip Brewer's picture

For example, you want to have some money in a local bank, because sometimes you simply have to have money that's right there in town (to bail a friend out of jail, or to get a certified check to close an important business deal).  On the other hand, maybe the internet bank pays a higher interest rate.  As long as you have the necessary sum in a local bank, maybe the rest of your cash can go in the internet bank and earn the higher return.

Another example would be putting some money into a near-cash investment, such as a savings bond.  Once savings bond is one year old you can redeem up to $1000 worth at any US bank any time during banking hours, and yet they often pay a much higher rate of interest than other investments that you can turn into cash wherever you happen to be.

My point is that the division ought to be decided on that kind of basis, not on the basis of what you're planning to use the money for.

Guest's picture
Slinky

But you put the money in those different accounts to take advantage of their benefits based on what you're planning on using the money for. How else do you know how much to put in each account type? How do you arrive at that "necessary sum"?

It seems like you're mostly concerned with having your money serve multiple purposes. Just because a person compartmentalizes, doesn't mean your money can't serve multiple purposes. When you decide how much cash to keep on hand in case of an emergency, you're designating that money for any and all emergencies. You don't sit there and save 5k in case the roof needs it plus 2k in case my transmission goes on my car plus 3k in case I get hospitalized for my asthma, etc. You'd never stop saving if that were the case!

People don't go on vacation instead of repaving the driveway because the market went a certain way, they go because people don't want to give up their fun to do what they should do. They do it because they think it would be nice to do both, but don't do what it takes to make that happen.

Guest's picture
Brian

How does that work with tax-advaantaged accountants such as IRA, 401ks, ta- adantaged college savings, Health Savings Accounts, etc? These all have rules about when and for what you can use them. If you use your 401k to sae for a goal before you reach a certain age, you will likley pay a penalty. To avoid that, you need to make sure the "labels" fir what you are planning to use the money for. In other words, to compentalize.