How does the Envelope system work?
Every dollar you have must have a purpose. Take your money and put them into separate envelopes, with each envelope serving their own purpose, say groceries. How much money you put into each envelope depends on how much money you budget for that category of expense.
When you need the money, say for grocery shopping, take it out from that specific envelope, and spend it. If you find that you run out of money, find other ways to survive.
But if you find yourself in this scenario too often, your budget might be too restrictive and you might need to channel some money over from an underspending account.
The trick to managing your financial life and not simply your budget
Have envelopes for your goals, savings, and investments, and do not restrict yourself to just spending on necessities and entertainment. Remember, every dollar has a purpose. You should create goals and budget a monthly savings towards each goal.
For instance, you can save up for a vacation, for a new laptop, or even a new car. Similarly, do it for your investments as well. Set aside a fixed amount of money to go into your "investments" envelope, and use this money to invest.
Over time, the amount of money you have in your "goals" envelopes will grow and you will be able to achieve your goals easily. This is also true for your "investments" envelope, whereby you will see your investments grow and grow over time.
You can read this post about how to invest: the simplest (and probably most proper) way to passive investing.
Handling one-time income or expenses
One-time income, such as bonuses or dividends from your investments, are a good thing. You can simply choose to increase your budget to some of your favourite activities, and put the money into your "movies", "football", or "shopping" envelopes.
Or, you can also be frugal, and put them into your "vacation" or "new laptop" envelopes and reach your goals even earlier. Lastly, you can also put them into your "investments" envelope and let it compound over time.
On the other hand, one-time expenses might pose a problem. The solution to this is to have an "emergency funds" envelope. This can be around 3 to 6 months of expenses, and pay off the expenses from this envelope. Whenever this envelope loses money, top it back up before you allocate money to your "goals" or "investments" envelope.
A case study on an average Singaporean
Consider an average Singaporean, Joe. Aged 25, he has a job, earning $3,000 a month, with take home pay of $2,400 and CPF contribution of $1,110. We can assume that he pays for his house using his CPF.
Let's see how the Envelopes system can help Joe. We find that Joe has a dream to travelling to Europe, and he wants to do it in 5 years' time. Joe found out it would cost at least $25,000, which means that he needs to save $417 each month.
Joe budgets $400 for food expenses, $100 for telecommunications, $100 for medical expenses, $150 for transportation, and $300 for miscellaneous expenses. This totals $1,050 each month.
With this, Joe has $933 each month leftover. Since each dollar must have a purpose, Joe decides to put all $933 into his "investment" envelope.
If Joe does passive investing, he can expect to achieve a 5% real rate of return on his investments annually, giving him an expected nest egg of $744,115 by age 55 (in today's terms). Assuming a withdrawal rate of 3%, he receives an monthly income of $1,860 from his investments (in today's terms).
Since this is higher than his monthly expenses now, he can retire comfortably. Of course, this does not include the increases in medical expenses as Joe ages over the years, but it gives an illustration of how the Envelopes system can help Joe manage his financial life.
Conclusion and some stylised rules-of-thumbs for effective financial planning
The Envelopes method give an easy way to manage your own money, and gives a clearer snapshot of how much money you need and have at each point of your life.
It is prudent to spend less than half of your take home pay on monthly expenses, and allocate around 25% of your take home pay to your investment account.
There are many applications out there which can help you with this Envelopes system so that you do not have to resort to withdrawing out all your cash and put them into envelopes.
I'm also trying to write an Android program that simplifies this Envelopes system as I feel that the solutions out there are too cumbersome with excessive features. Do look out for it as I will update you again!
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