If you want to work for money, you will be doing that throughout life. If you can’t protect your money, financial predators will chip it away. If you don’t budget your money, others will make you fritter it way. If you don’t invest properly in the right assets, your money will be eaten up by the monsters of income-taxes and inflation. If you are reckless and do not invest your money properly, you will lose your wealth at the next unexpected event.
Although we all love money, it’s difficult for us to understand money and very tough to achieve financial independence. That’s simply because we all “work for money” rather than making “money work for us”. In this article, I try to make readers understand the nature of money, solve its mysteries and how to make it work to achieve financial independence.
Enhance Your Income
The first and foremost thing is income. We all have to learn to enhance our incomes. We all have some talent—we have to identify our talent, hone our skills, gain experience, improve our networking and increase our knowledge because that is the key in the current high-flying technology and information era. We all have to try to consolidate our strengths and minimise our weaknesses and aim to earn as much as possible because income is the first tenet of the profit & loss account.
Start Saving Early
Whether it is life, sports, exams or any other activity, there is nothing better than starting early. There is a saying that what you plan to do tomorrow, do it today; it best applies to the world of savings and investments. For example, if one saves Rs25,000 annually at an expected rate of return of 10%pa (per annum) for 30 years, the total corpus would multiply to a staggering Rs3.80 crore. Now, for whatever reason, if that individual were to delay his/her decision by, say, just five years, then, at the same expected rate of return, the corpus would be Rs.2.07 crore, almost half the corpus in the first case. Thus, by starting five years early, one could have almost doubled one’s investment corpus!
Increase Your Net (after tax) Income:
Earning more income is just the beginning and will not, in any way, solve your financial problems, unless you follow the other rules. The second most important thing is to enhance your net, or after tax, income. There are lots of financial predators and the biggest amongst them is income-tax which legally picks money from your pocket. There are three kinds of income: 1) earned income (like salary where the person actually works to earn money), 2) guaranteed income (where the return is guaranteed like bank fixed deposits and, hence, there is negligible risk) and 3) portfolio income (where neither the principal nor the return is guaranteed like dividend from shares, rent from real estate, capital gains, etc).
Please remember, the tax structure is discriminating. As a general rule, there is maximum tax on earned income, as if the government wants to punish you for working hard to earn your income. Also, there is maximum tax on guaranteed income from portfolio because the tax policy assumes that you are an idle investor and, so, are not taking risk with your money to earn the return. However, the moment you are buying market-linked products, there is a lower rate of taxation from portfolio income. Hence, rather than working hard for your money and paying higher taxes, you have to be smart to let your money work for you and pay lower taxes.
Unnecessary Revenue / Capital Expenditure: Examples of unnecessary revenue expenditure are: a foreign trip, costly dinners at five-star hotels, etc. Unproductive capital expenditure would mean too much investment in assets which produce negative income, like car, holiday home, etc. But, we all have to incur expenses for our existence like food, clothing, medical, etc. Therefore, we have to learn to budget for these expenses and plan a judicious use of our finances. And, finally, what is the use of money if we can’t enjoy life? So, at some point of time, everybody has to incur unnecessary revenue expenditure or bad capital expenditure, but you don’t pay for them—let you assets pay for them. Treat all money equally, i.e., the money you got from, say, a lottery ticket or from the estate of a deceased relative or any windfall gain, with the same respect as the money you have earned from your hard work.
Keep a Contingency Fund Ready
The most certain thing about life is that it is uncertain. Therefore, everyone has to have a contingency fund; because you don’t want your long-term financial freedom to be sacrificed because of short-term problems. For example, one would hate to dip into the corpus fund set aside for one’s children’s education to meet an emergency medical need. Hence, keep adequate funds in liquid assets like short-term bank fixed deposits (FDs) or liquid mutual funds to meet any kind of unfortunate untoward emergency need.
An individual would have different goals in life which would demand varying amounts of financial commitment. There would be basic goals like food, clothing, shelter, education, medical, etc. Then, there will be lifestyle goals like car, consumer durables and the like. Finally, there would be aspirational goals like purchasing a holiday home, enjoying a costly foreign vacation or sending children abroad for higher professional education and so on.
Investing is not beating your neighbour, or performing better than some mutual fund manager. Investing is about being able to pay for all your future needs effortlessly, live a worry-free life and be able to achieve your higher self-actualisation goals. Therefore, the success of a goal-based strategy is measured by how well an investor’s portfolio is tracking against a stated goal.
A traditional investment approach generally focuses on outperforming the market while staying within one’s threshold for risk. A goal-based strategy uses individual asset pools with an investment strategy that is tailored to the client’s specific goals. The two biggest advantages of goal-based investing are: it increases one’s commitments to one’s life goals by enabling us to gauge tangible progress towards these goals, and it reduces negative behavioural biases such as impulsive decision-making and over-reaction.
Liability Side – Good Debt and Bad Debt
Learn to distinguish between good and bad debt. According to me, bad debt would be that debt which is used for unproductive capital expenditure. On the other hand, good debt would be that which helps you to create an asset which then puts money in your pocket (income) as well as scope for future capital appreciation, e.g., rental property which earns rent, shares which earn (tax-free) dividends. Also, both have potential for future capital appreciation. Never borrow to incur revenue expenditure, like a foreign trip or bad capital asset like a car or a holiday home, because they will not only take away money from your pocket in the form of interest payments but also put you into incurring wasteful revenue expenditure in the form of maintenance like petrol, repairs, property taxes, etc.
Asset Side—Create Good Assets: Always aim to create good assets which will provide income to you. For example, equities which will give you tax-free dividends, rental real estate which will give you rent, etc These have multiple advantages like they are either tax-free up to a limit (dividends) or subject to lower rate of taxation after exemptions (rent) than earned income (salary). Use the power of leverage to create good assets—let the income from the good asset pay your loan interest. And, once the loan instalments are over, the future income (taxed at lower rate) on the good asset as well as the good asset is yours for life. And the trick of enjoying life, as well as securing your financial future, is to ensure that the portfolio income from your good asset pays for your revenue expenditure or bad capital expenditure.
Don’t forget that income-tax reduces your gross income; interest on loans (on revenue expenditures / bad assets) diminishes your net income and inflation eats into your remaining income. Follow the simple rules stated above and you are on your road to achieving financial emancipation.