Personal Finance Management (Part - 1)

 

 

One of the most important things in life I am sure most of you agree is personal finance. The importance of personal finance was quite evident when the COVID-19 pandemic hit the world and people were literally in a state of panic and distress as to how to overcome the challenges faced during this period. In my opinion, it was a good reminder to everyone who went through this process that the importance of personal finance management is very crucial in life and earlier we start better is the results.

 

To begin with this topic, one has to ask a very basic question to himself/herself about the current net worth. In simple words,

Net worth = Assets - Liability

here:

• assets comprised of gold, money-back insurance policy, free cash, fixed deposit (F.D.), recurring deposit (R.D.), mutual funds, stocks, real estate (residential/commercial/agriculture), pension schemes, vehicle, etc.,
• liabilities comprised of loans (vehicle, home, personal, mortgage, over-draft, education, agriculture, credit card, etc.,)

While considering any of the asset classes (mentioned above) one has to know three basic principles, safety, liquidity, and return on investment. For instance, keeping a money in the bank's fixed deposit may seem like the safest and highly liquid option, but on the other hand, this particular investment yields one of the lowest returns in the above-mentioned category. So, it is clear that each financial instrument is a trade-off between safety, liquidity, and return on investment. One has to make a thorough diligence before making any sort of investment. Other key factors while considering an asset class are whether your financial instrument is considered as an appreciating asset (value increases with time) or a depreciating asset (value diminishes with time). A good example for appreciating assets is gold, on the other hand, car/bike/mobile phone for depreciating asset.

As a rule of thumb in investing the mainstream of income should be utilized for basic needs, wants, and savings/investing in the ratio 50:30:20. For instance, if you earn Rs. 10,000/- monthly from your main stream of income, an amount of Rs. 5,000/- is spent on basic needs such as room rent, utility bills, and other livelihoods. Rs. 3,000/- on wants such as electronic gadgets, vehicles, dining out, going for a movie, etc., and lastly remaining Rs. 2,000/- for savings/investing. One has to closely notice the last term savings/investing. As a saying goes "keep aside for rainy day" and I want to emphasize this part very profoundly because it might not seem really important unless a situation like COVID-19 or any other financial emergency comes and you are late to realize. Hence, in order to lead a peaceful and contentment life, keeping aside your earnings for a rainy day is very essential. Another objective of savings/investing is to beat inflation and experience the power of compounding over the period of time in wealth creation.

So, what exactly is inflation you may ask? Here is the definition from Wikipedia, "In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money". In general terms, it means that the price of a product increases with time. Just to give you further insight, I would like to remind you about your parents/grandparents saying that 30-40 years back the price of one kilogram of rice cost Rs. 2/- which has increased to about Rs. 50/- now. I think this is one of the classic examples of the effect of inflation on the day-to-day products we consume. India's inflation rate is about 5-8% which means, for Rs. 100/- you hold this year, the value drops to Rs. 93/- the next year for an inflation rate of 7%. See below an illustration of the effect of inflation for the 10 year period. The value of your money erodes about 50% every 10 years.

So, in order to beat the inflation (hidden/unknown cost), one has to smartly invest in a financial instrument that could overcome the inflation effect. To achieve this, one has to be aware of the estimated return on investment of each asset class we invest in.

Coming to the power of compounding, I would like to start by mentioning the very famous quote from Nobel prize winner Albert Einstein, "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it".

This is the open secret of every millionaire/billionaire who has built their wealth over a period of time. I would like to directly give you an illustration of the above statement below:

Consider an example with an initial investment of Rs. 1,00,000/- having compound annual growth rate (CAGR) of 12% over a period of 30 years.

 

 As you notice above the initial investment has grown about 30 times the initial value and it grows astronomically beyond it. Hence, I would like to emphasize again that the earlier you start investing in a financial instrument that could beat the inflation, greater is the corpus you build over time. The future value calculator can be found here.

 

For further clarification and/or personal consultations: fill out this google form (click here).

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By now you will be having a number of questions running on your mind as to how one can build his wealth? How to increase the mainstream of income? How to invest in different financial instruments? Well, I would like to share further insights in my future posts under the same topic name (find Part-2 and my source of learning). Until then thank you for your time and I am always open to the conversation and feedback from your end!