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Sludge! - How to identify and manage the financial sludge in your life

Previously, we discussed this savings waterfall. This is the approach we use to make sure our income finds its way to your long-term wealth-building. Today we are going to discuss expenses and potential obstacles keeping your income from making it to those long-term investments. We are going to discuss how to manage the “sludge” in your life!

About the author: Jeff Hulett is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM. Today, Jeff is an executive with the Definitive Companies. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his new book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions -- at

Please check out Jeff's YouTube channel for the VidCast of this article.

Be careful to manage your fixed expense payment needs to a reasonable percentage of your income - the 50% to 60% range is a good rule of thumb. [xiii] In "The Saving's Waterfall" graphic, this is the first horizontal bar at the top. When realistically possible, it is better to have a larger blue "Savings Eligible" portion. One of your biggest expenses is housing. The good news is, housing provides marginal utility and, if you are a homeowner, generally goes up in value. A win/win! Marginal utility means that housing's use as a shelter or other needs in the future is valuable to you.

However, sometimes people may get themselves into fixed payments that provide less or no utility in the future. There are two kinds of fixed payment types that may be particularly troublesome, contractual-based payments and sludge payments.

First, let’s discuss Contractual-based payments - These are payments made to a lender or lessor - like a credit card, lease finance company, or mortgage company. You sign a contract with a certain frequency of payments, either fixed or variable. The crux is, one does not have a choice but to make payments while there is still a debt owed. It is critical to make sure the marginal utility of that being financed is worth it. If you are spreading your payments over several years, then your marginal utility should match the same time period. Imagine the thing you are buying. Then imagine the same "thing" several years in the future. Will it provide as much value in the future as it does today? Be honest! In truth, this is a very challenging question. People naturally struggle with uncertainty. We have cognitive biases that sometimes make accurate future forecasts challenging.

To help overcome the uncertainty challenge, my rule of thumb is to only finance assets that appreciate in the future, like a house. Try to avoid using credit for assets that decline in value, like furniture or a car.

To sludge or not to sludge? - a car as an example of buying something that reduces in value. I get it - sometimes you need to buy something that declines in asset value but may have constant marginal utility. A car is a great example. Perhaps you need transportation to work. A car likely maintains a constant marginal utility because of the ongoing need to work or otherwise manage our lives. However, we need to recognize that most cars depreciate in asset value over time. [xiv] In this case, I suggest minimizing your exposure to the declining asset value while fulfilling the marginal utility of work transportation. In other words, buy as inexpensive a car as possible that still provides safe transportation.

Also, consider a car transportation substitute like ride-share or public transportation. To be clear, this suggestion considers a utility bundle that only values the "safe transportation" preference. You may have additional preferences to weigh. You may wish for a big car, a fast car, an electric car, a purple car, or many other preferences. Additional preferences will almost certainly add cost. The key is to evaluate those preferences in the context of the wealth-building approach suggested earlier.

Next, we are going to discuss the other fixed payment type called Sludge payments

Sludge is a funny word, usually associated with mud or slurry from industrial processes. In the case of behavioral economics, it has a different meaning:

Sludge is what behavioral economists call anything in a process that hinders people. It prevents people from doing the things they want to do and eventually reduces the consumer’s welfare. This means, you enter into a payment arrangement to receive some product or service, but over time the value to you goes down. Sludge is when you continue to make those payment even though the value to you is less.

A prototype for sludge is that many consumer products and services companies target customers for automatic payments. Think of your favorite entertainment streaming service like Netflix. Most streaming service providers offer incentives to sign-up for automated payments. The company knows that this is very sticky as people are much less likely to cancel these payments because they lack salience. [xv] These payments - what we call "sludge payments" - are minimally noticeable. Sludge payments are a "boil the frog" marketing approach pursued by many consumer products and services companies. Sludge payments become like fixed payments because they are likely to be forgotten. Often, the marginal utility of the underlying sludge payment's purpose may decline or become useless, even though people will still pay it! Based on the "Sludge" definition - this is the "reduced consumer's welfare" result. Check out the website, we provide sludge examples - Sludge in action!

The sludge challenge: Check your credit card and bank statements. How many auto-transfer transactions do you see? Do they have the same value today as when you signed up for the service? This is sludge payments in action!

The point is, whether contractual-based payments or sludge payments, people sometimes get themselves in trouble by overcommitting to inflexible fixed expenditures.

Finally, a great way to manage your sludge and other expenses is with a budget. There are many budgeting tools, please see the website for some suggestions. Consider using a simple budgeting model. Your budgeting tool should be something you can keep up with and that makes sense to you. Also, consider making your own budget spreadsheet in excel or google sheets. This is a great way to learn spreadsheet mechanics and create more personal investment in your budget. You may use the commercial budgeting tools as a template to build your own budget. Check out our website for suggested budgeting tools.

Managing you financial life starts with the savings waterfall and managing your expenses. The idea is that you want as much money to flow to the bottom your your waterfall to be available for long-term investment. Next, we will be discussing our investment approach called “The Barbell Investment Strategy.”

You may find more financial planning, budgeting tips, and suggested budgeting programs in my book.

Check out my website for details:


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