In a recent article, I discussed the two ways of viewing money that would change everything.  One of the ways was viewing money as capital; specifically, capital that is allocated one way or another.

Capital allocation is a fancy way of saying spending or investing.  Basically, you have money, or capital and what you do with that capital is called capital allocation.  How you allocate your capital will be a big part of determining how wealthy you become in your life.

When you allocate capital, there are three different purposes you have in doing so.  They are:

1. Out of necessity
2. For pleasure
3. For a monetary return

Allocating capital out of necessity

When you allocate capital out of necessity, you exchange your money for things you need.  These are food, shelter, clothes, etc.  Now, most of your purchases are a combination of necessity and pleasure.  For example, you need to eat, but most people don’t eat rice and beans every meal.  When you eat that expensive sushi, your purpose is both necessity and pleasure.  Another example is your car.  You probably need a car.  You don’t need a Range Rover.

Allocating capital for pleasure

As I mentioned above, you can spend money for pleasure.  While some pleasure purchases are a combination of pleasure and necessity, there are also strict please allocations.  For example, buying a boat.  Buying a boat is expensive and maintaining it is expensive.  They will also depreciate will you own it.

Allocating capital for a monetary return

The last purpose of allocating capital is to gain a return.  This is mostly in the form of investing.  You hope to invest your money in a way that the asset you buy will appreciate or earn a nice return over time.  Your 401(k), retirement accounts, trading accounts, maybe real estate are all examples of this.  Also, just as there are combinations for the previous two categories, you can also combine an investment with a pleasure allocation.  For example, upgrading your home might be a decent investment, but when you factor in the gain in lifestyle, it makes it a no-brainer.

Strategizing your capital allocation

They key to building wealth is to minimize the amount of money being allocated to necessity and pleasure, and maximize the capital being allocated for a monetary return.  While some people may live bare bones for a few years and put away as much money as possible, for most people (including myself) this is unrealistic.  I have a family, and while I may want to push our personal finance strategy to an extreme, my family members will suffer as a result; therefore, a balance is necessary.

A good method is to map out your spending patterns.  Try out a tool such as Mint.com.  Mint.com’s spending charts and graphs are absolutely amazing.  Then, identify some areas that you can cut back the “pleasure” from.  For many people, this may be food.  I easily spend too much money each month on food because I eat out a lot.  Eat in more, or eat by “necessity” rather than “pleasure”, and you might find yourself with more capital to allocate towards some investments.

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