Imagine staring at your bank statement and wondering why you’ve overspent again. You’ve tried budget apps, spreadsheets, the envelope system, and even zero-based budgeting, but nothing’s working. Does this sound familiar? If so, you’re not alone—and surprisingly, the solution might be to loosen up your financial planning rather than tighten it.
Our research challenges conventional wisdom about personal finance and offers insights that could revolutionize the way you manage your money. It comes down to two key strategies: setting optimistic (i.e. more stringent) budgets and accounting for atypical spending. While these strategies may seem counterintuitive, the evidence suggests they could significantly improve your financial health.
Traditional financial advice often emphasizes setting realistic or conservative budgets. Our study 2023 suggests otherwise. We analyzed more than 350 million transactions from 70,000 users of a UK personal finance app and made a startling discovery: setting optimistic budgets led to a 21.9% reduction in spending compared to not creating a budget at all.
Surprisingly, this effect persisted even when people did not stick strictly to their budgets. The impact of these optimistic budgets on spending was still evident six months later, despite people’s imperfect budgeting.
Take Audrey, for example, who normally spends $300 a month on groceries. Instead of setting a “realistic” budget of $280, she might set an optimistic goal of $240. Even if she ends up spending $260, she’ll still have saved more than if she had set a conservative budget or no budget at all.
“Atypical” expenses
Our second key finding concerns another aspect of financial management: predicting future spending. We found that a simple mental exercise—thinking about why your spending might be different in one month—can dramatically improve the accuracy of spending prediction.
In a series of studies with more than 6,000 participants, we found that when participants were encouraged to think about atypical expenses, their errors in predicting their spending were reduced by an average of 40%. This approach helps bring often-overlooked costs to mind, leading to more realistic financial forecasts.
Imagine Paul planning his monthly budget. Regular expenses like rent and utilities come easily to mind. But when he considers unusual expenses, he remembers that his car needs a (safety inspection) this month and that his sister’s birthday is coming up soon. This broader view leads to more accurate financial planning.
When creating a budget, take a moment to consider unusual, one-time expenses like car repairs. (Stock photo)
Interestingly, our research suggests that optimistic budgets and realistic forecasts serve different purposes. Optimistic budgets are most effective for reducing daily expenses. They act as a motivational tool, encouraging you to reduce small, frequent expenses.
On the other hand, realistic predictions are crucial when making important financial decisions. For example, take Theo, who wants to buy a house. To determine how much he can afford in monthly mortgage payments, he needs to predict his total monthly outlay on other expenses.
By taking atypical expenses into account, he can make a realistic forecast and avoid taking out a larger mortgage than he can comfortably afford. The same principle applies to other major purchases such as cars or household appliances.
Here’s how you can apply these insights:
- Set an ambitious budget for your daily expenses: aim for about 20-25% less than your usual spending.
- Make realistic projections when making important financial decisions. Also consider atypical expenses to get a comprehensive overview.
- Write down your optimistic budget and keep it visible.
- Don’t give up if you overspend. Use it as a learning experience.
- Before you start planning your finances, take five minutes to think about any unusual expenses that may arise.
- Review your list of atypical expenses monthly and update it as needed.
There is psychology behind these strategies. The effectiveness of optimistic budgets is related to the concept of reference points in behavioral economics. Even if we don’t exactly reach the goal, an ambitious goal influences our decisions and leads us to spend less.
