The road to Financial Independence (Part 3/3)

Note: This article is the third part of my earlier posts that can be found here: https://www.linkedin.com/pulse/money-whats-love-got-do-arnold-mascarenhas/

If you managed to improve your budgeting skills to a point where you are not spending all your income, and you have discretionary cash leftover every month, then congratulations! You are financially better off than most people out there. You are that much closer to financial freedom.

Like I said before, using your discretionary cash wisely is where the real magic happens. My parents were great at Steps #1 and #2, but somehow they never really learned to invest their money effectively. Don’t get me wrong, they are comfortable and have saved enough so that they can live middle class lives without depending on anyone. This is a great place to be, and I am deeply thankful for that. But the route to get there can be much simpler if we know what tools we have access to.

Understanding investing requires a certain level of self-awareness about what stage of your life’s journey you are on. It requires taking a step back and looking at where you are in life — what your short term and long term goals are, what dependencies you have externally and who depends on you. Finally, it often requires us to prioritise which goals we can realistically achieve.

For example, if you have parents who depend on you financially, you need to maintain the right cash flow to support them. Once you get married or buy a house, your financial equation evolves with maybe a new insurance policy or a housing mortgage. I may have an expensive hobby that eats up part of my monthly budget, but after my financial situation changes, being able to adapt to that and accommodate the new stage is important. Understanding the various elements that go into that equation is very relevant to one’s financial planning.

Once you take stock of all of these, that would reflect on the level of risk you are willing to take and therefore how much return you may receive from those investments.

Younger individuals can ideally take more risk with their investments than someone in their 40s or 50s (and beyond), because there is less time to make up for losses or corrections when one is older.

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Difference between ‘Assets’ versus ‘Liabilities’

There are a few simple concepts I believe we should be aware of before we move forward.

Assets, as the name suggests, are items that you own that add up to your net worth, you could sell them and get some cash back.

Examples include Cash, Stocks, Fixed Savings Deposits, Mutual Funds, Bonds, Government savings (like Provident Fund, National Savings Certificates), Real estate, Collectible Art, Private Equity, Cars, Furniture, TV etc.

Liabilities are amounts that you owe, could be to a person or a bank. Credit card debt, medical debt, any loans including house, car, motorcycle loans, EMI purchases, debt to a friend / family member.

Just like with your income and balancing your budget in Step #2 ( here), the goal is to have higher value in Assets vs your Liabilities. There’s no point having Rs 250,000 in Assets but Rs 450,000 in Liabilities.

Photo by Sven Schreiber on Unsplash

Types of assets — Appreciating & Depreciating Assets

Now that we know what Assets are, we need to understand — “ All assets are not created equal.”

The assets that grow over time (typically) in value are appreciating assets, and those whose value drop over time are depreciating assets. Assets like mutual funds, stocks, bonds, real estate are examples of appreciating assets.

[Note: High end art and vintage cars are exceptions, and they are a different asset category. The people who can afford the risk of investing there aren’t my target readers anyway]

Cars, electronics, furniture, etc. are all depreciating assets because the minute you buy them, their value has dropped and will continue to drop over time. There will come a time (over a few years) when no one will be willing to buy a second hand depreciating asset.

Taking on Liability (loan) for a depreciating asset is not the most financially savvy move, because you are paying interest for an asset that is dropping in value.

For example, taking a Rs 7,00,000 car loan for 5 years at 8.5% interest will cost you almost Rs 8,60,000. Basically you are paying Rs 1,60,000 more for an asset that will be worth Rs 4,50,000 (maybe) when you’re done paying off the 5-year loan.

This should not be interpreted as a recommendation to avoid buying a car if you depend on one for transportation for work, family etc. If you can’t rely on a substitute for transport, this becomes a ‘Need’ instead of a ‘Want’. P.S. Believe it or not, I have never owned a car.

Liquidity

But being able to manage what kind of car (model, new or used) we buy, will greatly affect the amount we need to pay over time. The same logic applies to all Needs & Wants. Living within our means will define how much disposable income one has to enable saving for other assets and reducing debt at the same time.

Last but not the least, I want to have a quick word on liquidity.

Liquidity refers to the ease at which an asset can be converted into cash. In case you have an urgent cash need, you wouldn’t typically sell your house, would you? That refers to liquidity.

Cash, by obvious inference, is the most liquid. Fixed deposits are almost the same, unless they are fixed term (or tax saving like in India) where one cannot terminate the deposit for a set period of years.

Equities and open-ended mutual funds can be sold instantly, but they take several days for the cash to hit your account. A house takes months (sometimes years) to sell.

Insurance cannot be sold, although some policies can be cancelled and we can receive a partial payout. Other tax savings instruments in India (like Provident Funds, National Stock Certificates, Tax saving mutual funds etc) are heavily illiquid and take years of continued payments to close out and receive cash to be able to spend.

For example, I have come across stories where individuals are sitting on large investments of real estate and other illiquid assets, but struggling to meet their ongoing expenses. I personally know several cases like this and it hurts me to see them unable to meet their property taxes and other personal expenses thinking they’re holding on to valuable assets. I have another story where someone passed away from sickness, the spouse and 3 kids collected the insurance and put 90% of the insurance money into an apartment. The kids were still in school, and the surviving parent had to worry about what next to feed and educate them.

Taking stock into the realities of liquidity can make a serious difference to our investment choices and our stability.

Think of liquidity in terms of ‘spend-ability’, and we can use the analogy of a clothes closet, a kitchen cupboard or a library bookshelf. We don’t keep all our clothes in our regular closet, do we? In the summer, the light summer clothes are kept close by in the regular shelves and easily accessible to us. During summer, the winter clothes are packed up and kept in storage, away in the attic or basement or just another cupboard that isn’t regularly used.

Look at asset liquidity in the same way. We do need to save up for a down-payment on a house or our kid’s future college education. However, we don’t need to keep accumulating funds in our regular account when the baby is only 6 months old. Stashing it away on a recurring basis into a higher returns investment is a wise financial move, and we are ok if it is not as liquid because we don’t need it right away. The same applies for emergency funds and short term goals. If we know we need some cash for a payment or expense in 12–18 months, investing into a longer term illiquid asset is unwise.

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Insurance and Emergency Funds

Once we understand the fundamentals of assets, liabilities, appreciating assets and liquidity, moving on to the next steps are much simpler. In order to start investing and creating a financial foundation, we need to first focus on protecting our future assets and ensuring we have emergency reserves for when life takes over. We do this by paying off our debt, and securing ourselves by acquiring the necessary insurance.

Insurance is also a financial product category that may not appreciate in the traditional sense, but will protect us when needed.

There is nothing we can do about it, the smartest thing one can do is prepare for when it happens. Health/medical/dental insurance, life insurance. Some financial firms offer injury / disability insurance in case one is injured and cannot work / earn for an extended period of time. The intention of doing this is in case something untoward does happen to us, it will not destroy our main investments that were planned for some other life goals.

Emergency Fund

I have heard of individuals who buy too much insurance (over-insurance) to protect themselves. The fear that unknown life situations will happen and we will not be prepared is a scary thing. But it is not prudent to be doing this or even thinking that way. The intention behind mindful financial planning and investing is to give us more freedom and better peace of mind, and this kind of thinking will give us unnecessary stress and is not worth it.

Apart from insurance, another ‘asset protection’ technique financially savvy individuals use is the ‘Emergency Fund’. Emergency funds are exactly that — funds for use in an emergency. Once in a while, things happen that our insurance cannot help us with. Job losses & layoffs, critical medical expense that insurance does not cover.

In order to be able to maintain a reasonable level of protection before we start growth investing, we need to work towards these steps with our disposable cash:

  1. Pay off debt
  2. Invest in the appropriate insurance that suit your needs
  3. Hold an emergency fund (3–6 months of your ‘Needs’, NOT ‘Wants’)

Some people prefer to have an emergency fund and a ‘sinking fund’ separately. The sinking fund is to be used when there are one-off non-emergency events only. For example, car broke down and need to pay for maintenance that isn’t included in insurance. Or your fridge conked out and you need a new one. These are important situations to handle and cannot be predicted, but they are not emergencies; so some people prefer to have this account separately so that their primary emergency fund is not depleted in case of a real financial emergency like a job loss.

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Growth Investing

Once we are in a position to protect our future investments (with an emergency fund and appropriate insurance), we can begin working towards growth investments.

It is important to note that there is no point mindlessly accumulating assets.

Simply accumulating cash & equities & insurance & real estate without the right coverage and goals in mind can be termed as only one thing — hoarding. This only protects the interests of the financial firms that are selling these products, not ours.

So many people do this on a day to day basis, and survive it only because of luck. In my opinion, this approach is pointless and if luck runs out, it can lead to difficult situations in times of need.

Ideally, we should be investing strategically towards our life goals. If we are able to forecast what goals we have, then we can invest in the right appreciating assets that will deliver the required returns to meet those goals.

Goals could include:

  • Wanting to buy a house for long term security and investment (Down payments)
  • Investing for life events that include marriage, children (their education and future)
  • Retirement
  • Travel plans etc
  • Big purchases

Being strategic about what you need, how much is needed and when you need it will help you plan more effectively.

However, there is no point investing in this yet if you still have debt. Ensuring you clear out large debt that is reducing your long term net worth should be your primary goal. In some cases (like buying a house, or a heavy education tuition), taking a loan is the most obvious way to make the purchase. However, these do become liabilities at that point. You need to account for monthly, quarterly or annual payments in your ‘Needs’ and see if you can manage making those payments long term.

Focus on Appreciating Assets based on Return on Investment (ROI) versus Risk versus Liquidity

Like I mentioned above, your focus is to build on your appreciating assets portfolio and invest strategically towards various financial goals. Depending on the timeline of these goals (short-term, mid-term, long-term), you can decide what kind of returns you need to be able to meet those goals for when the expense is expected.

The real secret to being able to achieve financial comfort is the ability to forecast your goals and expenses. This is something very few people spend time or energy doing, and that is the reason we are often chasing our tails behind unplanned expenses and living hand to mouth.

Once we know the timeline that these expenses are due, we can use our current availability of funds to invest towards those goals. This may sound really simple in theory, but it is hard to believe the number of individuals in their 30s, 40s and 50s who still struggle to do this.

Bonus Note: This is a very fundamental way to look at it, but if we are able to capture and internalise this information, you should be aware that this is exactly what General Managers at companies do when they refer to ‘P&L Management’. Granted the scale is more complex and larger, but it really comes down to the same thing. “How much do we spend, how much do we have left, what can we do to invest what we have and how can we grow it”

Watching out for Get-Rich-Quick Schemes

Finally, one additional comment — There is no such thing as quick & easy money.

Because we are enamoured by the appeal of quick, easy returns, we are often preyed on by various investment salespeople, high returns investment opportunities and straight out scams. A simple rule of thumb to follow here is to simply look at the returns being offered.

No matter what country you are in, look at a typical bank interest rate in your region, and the average annualised return from the stock market. Simple Google queries will do. If the investment is promising you a return lower than the bank, you obviously want to invest in a bank because it’s safer. However, if it is immensely higher than the stock market, rest assured the risk is extremely high. I hesitate to tell you that no one can deliver multiplier returns on an investment proposal, because it happens. But you have to remember that the risk to doing this is that high as well. Only invest the funds that you are alright taking that level of risk with; that is after you’ve planned out your goals from other investments.

I have made mistakes in the past, and I have been offered rates of return up to 40% annually. But I took those decisions intentionally knowing my money may not come back.

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With this, I conclude the three primary steps in Financial Literacy that we should all be aware of and that we should be learning academically. Only a fraction of us need to know the fundamentals of Hydrocarbons and Organic Chemistry in life, but every single one of us needs to understand how to live and manage our finances responsibly.

I hope you have enjoyed this Financial Literacy series. I would love to hear your feedback (negative especially), and if you liked this, please do share with your network so that we can all benefit from these learnings. I will continue to post more finance and non-finance related Life Skills and content for Lokyatha, so please do follow the page for more updates.

I wish you better financial health always!

Originally published at https://www.linkedin.com.

Lokyatha is an education focused initiative to enable young adults to live better, more fruitful lives by delivering real world life skills.

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