Personal Finance Management (Part - 2)

I am pretty sure most of you might wonder how one can build his wealth? How to increase the mainstream of income? How to invest in different financial instruments? Well, I will try to answer your questions here in this post. As mentioned in the previous blog post 'Personal Finance Management (Part - 1)' the main key objectives of saving and investing is:

1. Save for the rainy day.
2. Beat the inflation.
3. To experience the power of compounding.

Before understanding saving and investing, one needs to know about his psychology towards money. We humans naturally tend to express fear and greediness every occasion we come across a new financial instrument. Hence, it is good practice to understand us better before we start our investment journey. Ultimately it is not the one who has the higher money who sustains the game but the person who could control his emotions will be the actual winner. As mentioned in my earlier post before picking any financial instrument it is the trade-off between safety, liquidity, and return on investment. If one of the financial instruments seems very safe then it is quite evident those kinds of investment will yield a lower return. So, if you are at a young age (say 20-40 years old) it is recommended to take higher risk by investing in higher returns financial instruments, which correspond to about 80% aggressive investing and remaining in capital preservation. If you fall in the 40-60 years old age category, you should focus on about 40-60% aggressive investing and remaining in capital preservation. Lastly, if your age category is above 60+ years old then your focus should mostly be on capital preservation (80%) and a small portion in aggressive investing.

The next most important thing to know is whether you are a trader or investor? A trader is a person who actively buys and sells his stocks in a short period (day/week/month/couple of years) taking a margin out of his investment. The advantage of being a trader is that you could reap the benefits of the profits gained for meeting any short term goals, on the other hand, the main disadvantage would be that a reasonable portion of your money will be lost in the process of commissions/taxation and will not be able to enjoy the benefits of the power of compounding. Well coming to investors, it is quite the vice-versa of trader. You will enjoy the power of compounding and pay very low fees in commission and taxation.

Once you know the objective of saving and investing, the next important thing to build wealth is by increasing passive income. Now, you may ask what is passive income? To answer it, I will first answer what is active income. Here is the definition from Investopedia, "Active income refers to income received for performing a service. Wages, tips, salaries, commissions, and income from businesses in which there is material participation are examples of active income". To receive active income one has to be physically present to work and will receive the payment only if (s)he actively contributes to the work. On the other hand, passive income does not require your active participation in work. Income from rental property, dividends from the company are classified as passive income. So, if one can find an asset class that could generate more and more passive income, then one can increase his/her income stream without being actively involved in the day-to-day activities/less intervention.

By now you will be having a better picture of how to build wealth and increase the mainstream of income, one last thing to touch upon is the various financial instrument that is available in the market today (few of the financial instrument are not listed because of insufficient data). Below find various asset classes, estimated return on investment, liquidity, and risk involved.

 

 

You might notice from the above table that few of the financial instruments don't even beat inflation and hence it is clearly understood that most of the middle-class and lower-middle-class folks who invest in those instruments end up being in the same financial class even after decades of hardship. I want to insist it again that the open secret in building wealth is by beating inflation, letting the money grow with time (compounding effect), and having more than one stream of income.

Compounding means the money doubles after a certain period of time. In order to estimate the period in which the money doubles, there is a method called the rule of 72, where you divide 72 by the estimated return on investment which computes the period for which your money doubles. For investment in fixed deposits (F.D.), 72/7 ~ 10-11 years. Hence, if you keep your money in a bank fixed deposit it is expected that your money would take 10-11 years to double. On the other hand, the investment in equity/equity mutual funds would take just 3-5 years time to double.

 

I would like to end this blog post by giving you a classic example of the magic of investing in equity-related instruments and the power of compounding. Consider you invest Rs. 10,00,000/- and hold it for 30 years time, having compounded annual growth rate (CAGR) of ~26%. According to the rule of 72, 72/26 ~3 years, which means every three years the money double. In 30 years' time, totally the money double ten times. The corpus you end up with will be staggering ~100 crores INR.

 

 

 

 

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I hope you liked this post regarding personal finance management. Please find my source of learning here. I thank you for your time and I am always open to the conversation and feedback from your end!