All of us want to be wealthy. We all want to earn money and be able to have enough to meet our needs, lead comfortable lives, do the things we like, spend on things and experiences we want, and maybe just feel good about the fact that we are wealthy. The only problem is - we don't know how, and maybe even why?
I am sure anyone who is reading this article is well educated, maybe even an expert in some domain. But when it comes to personal finance, the domain which deals with our relationship with money in our lives, we are literally quite illiterate. In our upbringing - in most cases as middle class Indians - we have been taught to study hard and work hard, get good grades, go to good universities, get a good job, and grow professionally to lead a comfortable life. However, in none of these places we have been educated about money - how to save it, how to grow it, and how to make it work for us. Not in school, not in college, and not at home. On the contrary, the discussion about money with family is at best about advice, generally from the father to the children on savings, FDs and real estate; and at worst, a taboo which is never discussed.
So, when we start off, we don't have a plan and waste quite a bit of time (and money) in the process of figuring it out ourselves. During this process, we get influenced by others' irrational beliefs and fears based on their experiences, worse still, we get misguided by charlatans in the garb of advisors trying to help us, enriching themselves in the process. Fortunately for us, personal finance - the area of managing our spending, saving, borrowing and investments is not as complicated as it is made out to be (at least to reach the 80% level of being sorted). However, the basics is where we err. We focus on things such as alpha generation, chasing returns, identifying multibaggers etc. which are largely outside our control - while missing out on the basics which get us to the 80% level. We try to run, before we can walk.
This article aims to acquaint us with these basics, to give some structure to our financial lives, and hopefully, simplify the world of personal finance and investing to some extent. I do this in 2 parts - the Do's (which is covered in this article) and the Don'ts (Not doing) avoiding something is sometimes more important - Via Negativa.
The Do's:
Many of the points below may look obvious - and that's what they are. But often, we forget the obvious commonsensical basics, and focus on the challenging advanced concepts. We try to optimize output, while missing out on the input. Inputs are what we control, and that is what we look at below.
Define your objective - your financial goals
It is essential to define what your personal finance objectives are. They will be very different for each one of us, and will be shaped by our nature, upbringing, aspirations, affluence levels etc. If the objective is not clear, we will be lost in action - not knowing what we are working towards, taking unnecessary risk where it isn't warranted or shying away from taking an appropriate amount of risk, when we should. The way of figuring out your objective is by making what many call a 'financial plan'. A financial plan is a document which captures your current financial position, what your medium and long goals are and what that means in monetary terms, and finally derives a strategy for achieving those goals. It is an extremely personalized plan, and often is prepared iteratively based on what can be achieved, and adjusting your goals accordingly.
Developing a financial plan is a fairly detailed and involved exercise, in many cases requiring the help of a financial advisor / planner (someone whose incentives are aligned to your best interests, and not based on commissions from financial products which he/she recommends to you). However, in the spirit of keeping it simple, just think through what are your life goals for which you would need to build wealth - for instance, funding your retirement (an obvious one most people miss out), child’s education, buying a house, leaving behind a corpus for your child(ren).
Once you have these goals, each of these goals need to be translated into monetary terms - with a big factor considered - INFLATION. For instance, if your child is 3 years old, and one of your goals is to save up for her higher education, when she is 23 - then you will need to factor in the cost of education 20 years hence. So, if it costs Rs. 50 lakh today, with a cost inflation of 5% for 20 years, it is going to cost Rs. 1.32 Cr! (And historically, the cost increase in higher education has been higher that 5%.)
No one knows what future inflation is going to look like, or what is going to happen to the Earth by even 2050. The purpose of such an exercise is to try and experiment with a potential range of outcomes, to estimate what is the corpus you need to build, assuming a reasonable rate of return you earn. My assumptions of a reasonable rate of return to estimate my corpus requirements is ~10-11%, with 6% inflation assumption - this is what I use, you could have different assumptions. (My logic is average returns from stocks over the last 20+ years is ~14%, I am going to have some amounts in debt and cash, which would have lower returns, so ~11% seems reasonable.) Once again, the objective is to get a sense of what the the corpus you need to build, and how aggressive or passive you need to be. I can't control returns, so I try and control how much I invest.
This topic definitely deserves a deep-dive, which I promise will come out soon. In the meanwhile, there are a number of financial planning calculators available online, I would strongly recommend experimenting with them. I like the one from Capitalmind, it is simple and intuitive.
Start investing early
The earlier you start (saving and investing), the wealthier you will be. No matter how small the amount is. Rs. 100,000 invested at the age of 25 at 10% would amount to ~17,50,000 (~17.5x) at the age of 55.
Apart from the obvious advantage of compounding over a longer period of time, the simple act of planning and investing for long term goals earlier just let's you have a reasonable plan, without sacrificing too much at a later stage (either your goals are compromised, or your standard of living before hitting your goals), or making unrealistic / aggressive plans in the n-th hour.
For instance, one of the biggest needs for building wealth is to build a retirement corpus. With our life expectancies going up, we will need to plan to have enough to last us for ~30 years (if you assume cessation of a regular salary at the age of 60). And building this corpus while managing your expenses for nearly three decades (among other goals such as kids' education, large purchases such as homes) surely needs time, without having to hustle for an unsustainable rate of return on your investments or compromising on your lifestyle.
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Save and invest a reasonable portion of your income
How much you save would vary drastically depending on your income level, your age, lifestyle choices etc. But, if I were to take a shot at how much to save, I would say upwards of 20%, the more the better. This doesn't mean skimp on your needs or wants - if you have been eyeing that iPhone, maybe you should get it. But what it does mean is that you need to make a plan, a budget if you will. You need to sit with a pen and a piece of paper and make a plan as to what your income is, what are the regular spends you have, what are the one off spends on vacations and purchases you would need to make, and figure out what is left over. If what is left over isn't much, then re-look at your expenses, and see what can be reduced. The idea is to have a realistic saving target, and then follow through with it. And if some unexpected large spend comes up, find a tradeoff.
The other important thing is that you should aim to increase your savings rate every year. Assuming you are salaried, typically the salary increases by 8-10% every year, if not more. At the very least, if you ensure your expense does not increase by the same percentage as your increment, you would automatically save a higher portion of your income. If the increment is high, well, then you can save a lot more. (E.g., you earn 100,000 and spend 50,000 - 50% savings. Now with a 10% increase in income to 110,000 and a corresponding 5% increase in spending, your saving automatically goes up to ~52% of your income at 57,500 and increases by 15% as compared to the earlier amount of 50,000.)
Maintain an emergency fund of 6-8 months of expenses
All of us have experienced the uncertainties of life with COVID. Many of us, and people around us, have lost livelihoods and even lives when it was completely unexpected. Sometimes life is going to give us lemons - and we will never be able to predict when or what is going to hit us. All we can do is be prepared when it does.
A corpus of 6-8 months of our expenses, which is easily accessible when we need it will save us a lot of trouble. It will give us the cushion and time required for us to face the situation - whether a loss of a job, illness, accident etc. - and get back on our feet. And it will prevent us from making mistakes with our investments under stress, which can otherwise remain untouched.
Get an insurance - only to insure, not to invest
Going ahead with the thought about uncertainties, most of us should consider 2 types of insurance - medical and term (life) insurance (keeping aside the vehicle related insurances).
Medical / Health insurance is to prepare for any unexpected hospitalization expenses, which can otherwise cause a significant dent on our finances. I think every adult needs this, and should ideally take a personal cover (individual or a family floater) of whatever amount he / she seems appropriate, early on in life. It should aim to cover 80% of your hospitalization expenses in any given year. It can always be topped up further if you think the cover is inadequate.
Term or Life insurance is basically to provide for your dependents, should the worst happen to you. This is especially for the earning member of the family who has dependents, and a ballpark cover required is ~25x your annual expenses - this is debatable though and it needs to be assessed for every individual. Needless to say, if you don't have dependents or if you you have reached an age where you are not earning, you don't need a term policy.
A note of caution though - There are a number of other insurance linked insurance products (e.g., endowment plants, money back policy, annuity policy etc.) which I would recommend you to keep away from, unless you have an extensive understanding of the mechanics, commissions, liquidity constraints etc. More on this in Part 2.
Keep your expectations reasonable
Over the last 2 years, there have been so many new investors who have seen 100%, 200% and even 500% gains in some stocks, cryptocurrencies and other assets. However, we need to realize that this is not the norm. The markets (indices) in India have offered an average growth of ~13-14% over the last 20+ years, and expecting anything more than this is just going to disappoint, or worse, lead to non achievement of your planned goals. Moreover, we also need to realize that markets often give negative returns ~20% of the time - and that is a part and parcel of investing. To give you a perspective, I am sure all of you have heard about Warren Buffett and his phenomenal returns - well they are ~20% (and not 40-50% which people generally expect) - and he is among the best investors in the world. What matters is that he has made over several decades, making him among the richest billionaires in the world. The point is, don't expect to perform better than market average (you can hope for it, but don't plan with it), and that has been ~13-14%.
Keep it simple
Not everyone knows or needs to know everything about investing. Most of us have our hands full with our day jobs, families and hobbies, and don't have the knowledge, temperament or time to research the next multibagger, track markets and pick consistent compounders. And that is okay. There are those who enjoy doing this, there are professionals who do this for a living. But for the rest of us, there are avenues - generally mutual funds - where we can invest, either in an index fund or in a broad based actively managed fund.
A simple combination of equity and debt mutual funds (between 3 and 6 funds) is a very reasonable investment vehicle for most individuals which will help you build great amounts of wealth over time. Unfortunately, the mutual fund industry has made life complicated with hundreds of funds, large number of categories, channels (regular vs. direct), options (growth vs. dividend) etc. While it may be inappropriate to point out which 5 mutual fund schemes to invest in (simply because the needs would vary with every individual), I would go ahead and say a combination of a large cap and mid cap equity fund with 1-2 debt funds would be good for 80% of the folks. When it comes to find selection, stick with a fund which has a good history (avoid new ones). Honestly, the performance of these funds (in a given category) vary across the years, and it is difficult to conclusively choose one over the other. If you want to keep it even more simple, you can explore low cost index funds. Going over the nuances of mutual funds would need an article in itself, so I will stop here.
And then there is this heated debate of the ratio of equity and debt investments (and others assets such as Gold - Asset Allocation as is usually called). And people come up with formulae such as 100-age as the % in equity and PE based debt to equity mix etc. Honestly, if I have to take a call, for most readers of this article 60/40 or 70/30 in equity/debt. Just pick one, and move on. Keep it as simple as that!
While we have seen the simple things to ‘Do’ in this article, it is equally important, if not more, to understand the Do NOTs - which are covered in Part 2 of this article. Coming out soon.
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