“Face reality as it is, not as it was or as you wish it to be.”
― Jack Welch
In my previous two professional incarnations, I had a lot of opportunities to work with six sigma techniques. Popularized by Jack Welch at General Electric, they are ways to measure, using data rather than hunches or feelings, how well a system is performing or how well someone is doing on the job.
Can you use six sigma techniques to improve your personal finances? What the heck is six sigma? Read more to find out!
When I worked at Capital One, I was responsible for, among other things, the teams that forecast all of the calls that the credit card division would either receive or make in a given month. This was important because we set goals for customer service (yes, you can feel free to add derisory, scathing remarks in the comments!), and in order to meet those goals, we needed to have a sufficient number of representatives answering phones. If money were no issue, we could have put tons of people on the phones at all hours and nobody would ever have to wait on hold. Alas, those representatives cost money, so we wanted them on the phone as much as possible, which meant that we had to balance service with cost.
The telephone system – the one that answers when you call Capital One and asks for your card number and what you want to do – was designed to be the buffer between the caller and the representatives. If you could use a DIY method to get the information you needed, such as finding out what your balance was or making a payment, then we wanted the computerized system to handle it.
We had to take a lot of factors into consideration when determining how many calls would actually make it through to the representatives. Was there a new marketing campaign? Were we changing the automated system that answered the phone? Was the moon aligned with Mercury that month?
Bad forecasts were costly, so we employed lots of smart people with advanced math degrees and sophisticated software systems to crunch tons of numbers.
Behind those smart people and sophisticated software systems, we used pretty simple six sigma measuring techniques, which I’ll explain in a bit.
When I co-founded the software development company, we faced somewhat analogous problems. We billed by the hour, and when a customer asked us to fix problem X, they wanted to know roughly how much it would cost. Our geeks (I use the term lovingly) had to estimate how long it would take them to fix problem X so that we could quote a ballpark figure back to the client. No client liked to be quoted X and then receive a bill of 2X, so we needed to make sure that our estimates were reasonably accurate, lest we have to either present a large bill and tick the client off – ensuring no future work, or we have to perform a lot of free work.
Those of you who have worked with software before know that it usually takes twice as long and will cost three times as much to do a project as you originally estimate.
To help keep those costs under control, we implemented a basic six sigma method.
You can apply these same six sigma methods to your personal finances.
What is Six Sigma, and How Does It Apply to Your Money?
I’m going to have to dive into a little bit of mathematics to explain what this concept is.
If you have a group of numbers, you can add up the numbers, divide that total by how many numbers are in the group, and you get an average. Then, you can determine how far each individual number is away from the average.
Let’s say you have the following numbers.
The average of those numbers is 6.71. 1 is 5.71 less than the average. 8 is 1.29 more than the average. For each of those differences, you want to take the square of the difference, so for 1, the square of the difference is 32.65, and for 8, the square of the difference is 1.65.
Keep adding up those squared differences from the average until you’ve calculated them for all of the numbers – in this case, 129.43. Divide by the total of numbers in the group, and take the square root of that number. That number is the standard deviation, or sigma: 4.3.
What does that mean?
It means that in 68% of the cases, the numbers in the set will be between 2.41 and 11.01 (+/- 4.3 from the average).
That is called a one sigma deviation.
95% of the cases should fall within two sigmas, and 99.7% of the cases should fall within 3 sigmas.
Why is this important?
Personal finance involves forecasting. A good financial plan involves forecasting returns on your investments, how much money you’ll make over time, and how much you’ll spend. While your control over the first is somewhat limited (assuming you don’t take large investment
gambles risks), your control over the latter two is high. You can work more, work harder, and work smarter, and you certainly control how often you reach into your wallet or pull out the credit cards to buy things.
Don’t worry. This isn’t going to turn into a lecture on the virtues of frugality. I wholeheartedly believe in spending differentially on the things which matter most to you.
It is a lesson, though, in sticking to a plan.
Part of understanding how well your plan is working is to actually track how well you do compared to what you’d planned to spend in a given month.
We are much more interested in projecting out monthly budgets than we are in retroactively evaluating how we did.
Evaluation often involves admitting we didn’t succeed. It’s easier to pretend the shopping spree never happened or to write it off as a one-time event if we don’t look in the financial rearview mirror.
Instead, we need to be more complete in our budgeting process. Not only do we need to do budget projections – estimating how much we’ll spend in a given month – but we also need to evaluate how well we lived within those boundaries once we set them – did we spend more or less than we budgeted?
The obvious problem is when we spend more than we budgeted. We had set limits to our spending for a reason, and then we passed them without so much as a glance back. We all understand the havoc that can wreak on one’s long-term financial plans.
However, underspending is also a problem. When we have money left over at the end of the month, our limbic systems, what I call Monkey Brain, since we share this section of the brain with simians, alert us to the fact that we need to spruce up the man cave or that we could use a new pair of Jimmy Choo shoes, and, almost invariably, rather than putting that money to good use – spending which aligns with our priorities in life – we blow it and then look back a little while later and wonder where it all went. If we budget appropriately beforehand and have a plan for the excess money, we’ll put it to good use rather than to all the uses our Monkey Brains can dream of.
How do we fix it if we miss our estimates?
There are two ways to address missing your estimates:
- Change your estimates. Maybe you’ve been fooling yourself a little. You say that you only go out to eat twice a month, but the reality is that you go out four times a month. Your budgets have always had enough for going out twice a month, but they need to be upped to reflect the reality that you’re going out once a week.
- Change your behavior. A lot of people go through life not really aware of what they’re doing. Sure, in the moment, they know that they have gone out to eat, but when they look back, Monkey Brain wants to keep having fun, so Monkey Brain rewrites history a little. Going through the process of actually measuring how well you stayed within budget can identify the truth of what’s happening and can allow you to make changes. If you’ve been saying that you only go out to eat twice a month but the numbers tell you that you’ve gone out once a week, you can be more aware of your choices and change your behavior.
How to measure how accurate our budgets are
The standard way that six sigma experts measure accuracy is through the use of a control chart. A control chart simply plots instances when a value falls outside of a given sigma range.
In this case, we would use a control chart to determine when our budgets are way out of whack so that we can evaluate what happened.
An example control chart may look like this:
Naturally, this person’s budgeting efforts need work. Monkey Brain has a strong hold on this person’s wallet.
If you’re mathematically inclined, you can build a similar control chart using Excel. It took me about an hour to put that chart together using actual data; people who are very comfortable in Excel could do it in about 30 minutes. People who are familiar with, but not skilled in Excel will probably need 2-3 hours of using Google to figure everything out.