We keep hearing financial gurus’ saying things like start early, diversify, be patient, think long-term, align investment to your financial goals so on and so forth. In this article, I will try to decode the underlying principles behind these pearls of wisdom.
“Start saving as early as possible“ – irrespective of how much it is. In addition to the power of compounding, it helps you get into the rhythm of savings and also learn the ropes of investing with small amounts. Personally I believe that parents should give the same focus for their children’ wealth-being as much as their well-being and education.
“Save before you spend” – Most people I talk to claim that they will save what remains after their spending, will start saving from next month or year as currently their income is not sufficient enough to save. One of Warren Buffet quote is “Don’t save what is left after spending. First save and then spend whatever is left after savings.” However small the amount is, make sure you save before you spend. 5% of your income is the absolute minimum you should save – even if it means foregoing one movie, one weekend at a mall or any other expenditure you can reduce.
“50-30-20 thumb rule” – Attributed to Elizabeth Warren, the rule is that spend 50% of your after-tax income on needs, 30% on wants, and 20% on repaying debts (if any) and investing. This 20% is the minimum you should target for. Depending on your situation – say if you are young, earning and living with your parents, you may be able to save even up to 80%. Remember the power of compounding!
“Have budgets” – Though not my personal favorite, I think budgeting is a good way if you are not able to save. Budget helps you see where your money is being spent, helps you distinguish between needs and wants, and also gives you an idea of how much you should have in your emergency fund.
“Saving is not same as Investing” – Saving is about ensuring that your expenditures is within your income and there is surplus. Keeping this surplus in instruments like savings account whose rate of return is less than the prevailing inflation rate means that your money is decreasing in value. Investing is about making your money grow sufficient enough to beat inflation and is a means for meeting long-term financial goals.
“High Risk – High Rewards” – If the risk is higher (and there is uncertainty), the investor needs to be motivated with the probability of higher returns to compensate for taking the additional risk. This is also called as “risk-return” trade-off. Risky instruments like mutual Funds, shares and bonds generally have average returns that are higher than the guaranteed schemes like fixed deposit and PPF.
“Diversify” – It is nothing but the age old wisdom of “never putting all your eggs in one basket”. Diversify your investment across instruments – PPF, SSY, Debt funds, Government securities, Corporate bonds, Gold, Mutual funds, real-estate and stock market. It helps you reduce the overall risks, balance the returns even if one or two instruments are in the downslide, and enables you to be patient and not forced to sell your investments at a loss. Again, do not overdiversify as it may lead to difficulty in managing as well as higher costs due to various types of charges.
“Avoid knee-jerk reactions” – Let me explain what I mean by this by giving an example. One investor came to know that compared to regular funds, the expense ratio of direct funds is lesser as there is no commission or distribution charges. Immediately, the person closed all the regular funds and reinvested the same in direct funds – there by saving the expenses.
Now what is wrong with that? The tax implication was not considered. In closing all the funds, the person had to end up paying tax – ranging from 10-30% depending on the type of fund. The tax paid on that year is much higher than what the person could have saved in expenses for the next few years.
So what could have been done? Stop further investments in regular funds and invest in direct funds from now on. Slowly redeem the existing funds – and avoid or reduce tax by spreading the redemption of existing funds over next couple of financial years. Note that the long term capital gains up to ₹ 1 Lakh is exempted every financial year.
“Align your investments to your financial goals” – Each of us have our priorities, needs, goals and that is why it is important to take control of our finances and not try to just copy or follow someone else’s footsteps. For example, if you are aware that your child’s higher education costs are to be incurred next year, it is better to book your profits in the risky share market and move the amount to a guaranteed instrument – even if the market is rising (as no one can time the market).
“Take inflation into account while setting your financial goals” – When I was in college, independent houses costed around one lakh Rupees and when I started earning I was planning to buy a house once my savings hit the one lakh mark. And when I did buy a apartment (could not afford independent house), the one lakh was not even sufficient to self contribution requirement of the housing loan. The point is when you planning for a future financial goal, the target amount should include the effect of inflation (defined as the persistent rise of prices) that results in decreased purchasing power of the money.
“Insurance, while essential, is not an investment” – Insurance (Life, Health, Home, Vehicle, Travel etc.) is necessary but its purpose is to protect you and your family from unseen risks – making it essential for your peace of mind. Looks like our averseness to buy term insurance (which is the only pure insurance product – and the only insurance you should buy) as “we do not get back anything” has resulted in insurance products being camouflaged as investments (more like sugar coating a bitter medicine). Will try to cover this aspect on why not to mix insurance and investment at a later article. Right now, just want to highlight that buy term insurance and be cautious (avoid as much as possible) when considering child insurance plans.
“Think Long-term, and Be Patient” – For long term goals, like building a retirement corpus of ₹ 5 Crores, even if the market is crashing do not quit – but use it as a opportunity to buy more as historically the share market recovers and even grows after a crash – however bad it may seem. Rich people build wealth by staying invested long-term and not by fluctuating from one instrument to another, every time there is a fall. Changing portfolio frequently only leads to increased charges, unexpected taxes, and missed opportunities of letting the money benefit from compounding.
“Monitor your investments regularly” – While seeming to contradict the previous point, in reality it is more of a complementing strategy. Monitor your investments regularly to see if the returns are as per your expectations, if it is inline or better than the benchmarks, see if some adjustments and reshuffling is needed. Make your changes and choices looking at your overall portfolio and the external market situation.
“Spare time and do your home work” – Irrespective of where you get the idea from, before investing or quitting, spare some time, use the wealth of information available online and make your decision. Consider the risks, alignment with your financial goals, tax implications, charges like exit load and if the choice is the best for you at that point in time. Personally I delayed investing in National Pension Scheme (NPS) by a decade based on a water-cooler conversation.
“Wealth Paradox – Income does not translate to Net worth” – It is all about Net worth that is different from income. Net worth = What you own (assets) – What you owe (liabilities)! Your net worth gives you an indication of your financial health.
If you think your income is low, do not let that stop you from taking the journey toward financial independence. It is a fact that many low earners have a higher net worth than persons who earn much more than them. Pause a minute and think of it! Low earners who start early, save the maximum they can, invest in profitable avenues, be persistent and patient can build their net worth over time. Remember the adage “Rome is not built in a day!”
Are you a “HENRY” – High earners, not rich yet – with significant discretionary income (the amount that remains after tax and needs) who end up spending most of it? If yes, you are “working rich” (meaning that the person can live like rich only as long as they are working) who is the target of luxury product markets and rather than in the path of “becoming wealthy”! The recommendation for HENRYs is – to become truly rich– take stock of your situation, start by calculating your current net worth, check your impulsive spending, save more, diversify your investments and if needed.
#NetWorth #StartEarly #Compounding #WealthParadox #Diversify
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