by Anand Saxena
What actually happened was that the purchasing power of your money got eroded by a phenomenon called ‘inflation,’ which is nothing but a rise in prices of goods and services over time. In India, we look at basically two types of inflations: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI). The WPI compares the wholesale price of a basket of 697 goods (manufactured products, food items, fuel and water) month on month, whereas the CPI compares the price of a basket of 260 items of goods and services at retail customer levels, month on month. We, as common persons should worry about ‘retail inflation’ which is based on CPI. In India, it is the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) which sets the inflation targets which are flexible but generally within a range of 4 percent, plus or minus 2 percent.
So if the dress at H&M which sold at ₹5000 has gone up to ₹5500, the inflation is up by 10 percent. Simple? Well, all you need to remember is that over time nearly all the items or services you buy or consume will get costlier generally corresponding to retail inflation.
The fact of the matter is that irrespective of how much we earn, it can never make us rich. We will create wealth only if we can put our saved money to work in a manner that it keeps generating ‘real returns’ over time, meaning returns obtained after catering for inflation.
I would like to congratulate you to have the discipline and perseverance to have saved diligently for your dress. Try to do it better from next time on by ‘investing’ and not ‘saving’ because your piggy bank cannot beat inflation. But then what could? We will tackle this question in detail later but it suffices to say at this stage that in India the rate of inflation over next decade is likely to be around 5-6 percent as per the forecast of the International Monetary Fund (IMF.) Hence wherever we invest our money, it must give us a rate of return of more than 6 percent or else like our piggy bank, the money will be eaten. Even keeping our money in bank savings account will not be good enough where one typically gets a return of just 3-4 percent.
The ubiquitous rupee-draining power of inflation gets even more severe in sectors of real estate and education—two areas on top of the mind of every parent and student. In Mumbai, for example, the price of per square foot of land has gone up by 2205 times in last 55 years. Similarly, the money required to obtain a two-year MBA degree has gone up from ₹3 lakhs in 1999-2000 to nearly ₹25 lakhs today.
Key Takeaways
The mantra of saving has to shift to investing and that too wisely, to beat the rupee-draining power of inflation.
Wherever we invest our money, it must give us a rate of return of at least 6 percent. The avenues to achieve the same will follow in subsequent musings.
MUSING 2: COMPOUND INTEREST
THE EIGHTH WONDER OF THE WORLD
“Wealth, like a tree, grows from a tiny seed. The first copper you save is the seed from which your tree of wealth shall grow. The sooner you plant that seed the sooner shall the tree grow and the more faithfully you nourish and water that tree with consistent savings, the sooner may you bask in contentment beneath its shade1.”
There is this famous story, probably apocryphal, that Albert Einstein once termed the ‘compound interest’ the ‘Eighth Wonder of the World.’ While this may or may not be true, if there is only one concept from this book that I wish to leave with you, it is to understand and internalise the power of compound interest. Like all great powers it can be harnessed to achieve absolute financial freedom or conversely, it can land one into penury in the sunset years, all other factors remaining same. To explain this and the subsequent concepts, let me now introduce you to the protagonists of these musings: Anshreya and HoneyCool. But first, let us recapitulate as to what we mean by compound interest.
“Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest2.”
Anshreya is 25 years old and has just started earning with a decent and stable job in a field that she loves. Her take-home pay after taxes and other deductions is ₹50,000 per month and she currently has no liabilities including student loan, home loan or other Equated Monthly Instalments (EMI). Being a financially wise and savvy youngster, she decides to invest 20 percent of her take-home pay—₹10,000 per month into a financial instrument which over the long-term gives her a return of 12 percent (we will tackle the types of instruments available later.)
Anshreya has a friend, HoneyCool, who wants to enjoy his life in the initial years of his earning career and decides to start investing after five years. So he starts investing the same amount i.e. ₹10,000 per month after five years and manages the same returns as Anshreya. Both invest religiously till they retire at the age of 60. What would be the difference in their retirement corpus with the delay of just 5 years over their 30 to 35 years of investing life? Take a guess: Well, Anshreya ended up with a retirement corpus of approximately ₹Five and a half crores whereas her ‘live your life’ friend HoneyCool ended up with only ₹3 crores3–not a bad amount overall but really peanuts in front of what Anshreya accumulated (all examples factor in annual compounding.)
And mind you, here we are not considering the fact that Anshreya will keep on increasing her investment amount every year in line with her pay raise to cater for inflation, so the actual final corpus will be even more formidable. How formidable? Well, if both increase their contributions by 6 percent each year (the likely inflation rates,) Anshreya ends up with a corpus of, hold your breath: ₹9.5 crores while HoneyCool is still a distant second with approximately ₹5 crores.
What this additional amount of nearly four and a half crores is going to do to Anshreya’s sunset years can well be imagined. The annual visits to exotic foreign locations, travelling business class and staying at choicest of the hotels and Villas, buying expensive and valuable gifts for her near and dear ones, ability to fund education of her grandchildren and contribute handsomely to social causes which she held so dear all her life besides leaving behind a rich financial legacy to her offspring. And what was the sacrifice she had to make for this blessed 25-30 years of retired life? A bit of frugality for first five years of her life; not a bad bargain right? Remember, being frugal is not the same as being miserly.
But like all great powers, wind, water and fire, compound interest can also cause serious damage if not harnessed carefully. To continue with our example, HoneyCool was not able to invest his money as wisely as Anshreya for variety of reasons (we will tackle the possible reasons later) and managed a return of 10 percent instead of the 12 percent that Anshreya did. With this 2 percent annual compounded loss to the returns, now what will be the final corpus of HoneyCool? Around ₹Three crores and seventy lakhs. How does that compare with Anshreya’s corpus of ₹Nine and a half crores, not very favourably I guess?
Key Takeaways
It is not important as to how much you earn but how much of it you get to keep and then put it to good use by investing wisely. There are many Hollywood and Bollywood stars, sports and music celebrities who were millionaires one day and yet died in penury.
The real power of compound interest is experienced over long periods of time. So, start investing with your first pay check (even beforehand, if possible.) After all, we all get pocket money.
Investing should be a habit, which should not be dependent on other factors like festivals, visits or a newly launched smartphone which demand extra expenditure. Once you decide on the percentage of money you are going to invest each month, it should be sacred, never to be interrupted. How much should one invest, will follow in the book.
Invest wisely to protect your capital and grow it at a handsome rate. Any loss in rates of returns will severely erode your net worth due to the tyranny of compounding. We will tackle ways to avoid it subsequently.
Resist the temptation to dip into the corpus for any
want, as the power of compounding punishes even one missed inflow or withdrawal.
MUSING 3: PAY YOURSELF FIRST
“I found the road to wealth when I decided that a part of all I earned was mine to keep. And so will you.4”
It is a great liberating feeling when you start earning with money flowing into your hands for which you are not accountable to anyone, except to yourself. And that’s the reason I’ll discuss this amazingly simple, yet profound concept: ‘Pay yourself first’ in the initial musings itself. This concept has been beautifully put together by George S Clason in his classic book on personal finance – “The Richest Man in Babylon”; published in 1926 but still mint fresh in its simple yet insightful teachings. This concept has been further elaborated upon by many authors including Richard Bach in his book “The Automatic Millionaire”. Both these books are available on YouTube as audio books which one can listen to while commuting for work, during a workout at gym or during morning jogs. I have extensively used this dead time to enrich myself with the wisdom of these and many other masters, for free. You may well ask as to why someone should teach you to pay yourself first when you are in fact being paid by your employer on the 1st or another date of every month. While that is true, ask yourself, are you really paying yourself first when you receive your pay check?
To begin with, the government takes its share from you in the form of taxes even before you receive your pay, followed by your employer in form of deductions as applicable to your line of job. As if they were not enough, you pay rent to your house owner, gas station for filling fuel in your vehicle, Pizza Hut for the pizza and H&M for your clothes—the list is endless. While making all these payments, where have you paid yourself—not first, I guess? The fact about most of the people is that by the time they are through paying everyone else, there is nothing left for paying themselves.
Pay yourself first concept envisages that you set aside and invest a pre-decided percentage of your pay for your own future before anyone has access to your money. If you do it smartly, you would end up saving part of your pay that the government would otherwise have taken in the form of taxes. Secondly, what does not come into your hands at all, is not missed. So, the ‘pay yourself first’ part of your pay will be notional to you and you will learn to manage your expenses within the rest of the available money.
You might ask if you are not even getting to use that money now, how could it qualify as paying yourself? Valid question, but always remember, this money is being kept aside for you and your family’s future and not for anyone else. All savings/Investments you do today are a current sacrifice which will pay you handsomely later, especially when your earnings would have dried up and the requirement of medical and other old age expenses gone up. In a way, by your diligent and systematic investments, you would have created a ‘money machine’5 which will generate a perennial cash flow and ensure that you don’t have to work and yet get paid in your later years.
How do you go about doing it? First, ask your employer about the Employee’s Provident Fund (EPF) or other Provident funds and contribute the maximum amount allowed, to it. In many cases, the employer matches your contribution, till a certain upper limit, so you get additional free money as investment. The interest earned is also tax-free. Secondly, plan all the Systematic Investment Plans (SIP) of your investments—be it for retirement or children’s education, to be debited on the first day of the month itself. Thirdly, use all the means available towards tax saving (just note sections 80 C, 80 CCD and 80 CCD (1b) of Income Tax Act for the time being, which allow you to save ₹2 lakhs towards taxes,) EPF, Public Provident Fund (PPF,) and National Pension Scheme (NPS.) Since all these deductions towards your tax exemption and investments are taken out either before you receive your pay or alongside it (remember the first of every month for SIPs) you will be forced to manage your expenses within the remaining part of the pay.
The next logical question to ask will be how soon after one starts earning should one start paying himself first? After all, when one gets the first pay check, there is a lot one wants to do. The swanky bike, the sleek smartphone, taking friends out for dinner or buying gifts for parents, siblings or girl/boyfriend—all (legitimate) reasons will be jostling for your mind space and will delay paying yourself first, maybe just for a couple of months. Nothing very alarming, but few things will happen. Firstly, you will get comfortable with all the money coming into your hands and any cut in that money later, even to pay yourself will appear to be a deprivation. Secondly, the couple of months will quickly get converted to a couple of years and you will end up losing the all-important power of compounding.
You would remember our protagonist, Anshreya from previous musing? Well, she has decided that she would delay her ‘Pay yourself first’ strategy by a year, by which time she would be able to meet all her “obligations”. Her take-home pay is ₹50000 and she very religiously starts to save 20 percent of that after one year of her starting to earn. Now all other parameters remaining same as we discussed earlier, how much will be her nest egg at retirement – ₹Eight and a half crores; pretty sizeable, right? But take a pause and reflect upon what was her nest egg in the previous example: ₹Nine and a half crores. Yes, she is poorer by ₹One crore at retirement because she did not start paying herself first, from her first pay check onwards and delayed it only by a year.
Does this mean that life, after one starts earning has to be a drab and dreary affair where one can’t have any fun? Absolutely no; one’s life has to be in a beautiful balance where all the wants and needs are equally satisfied. So there is a place for parties, smartphone and gifts, alongside savings; one just has to prioritise. We will tackle these issues in forthcoming musings. And finally, the big question, how much should one pay herself first? Well, the originator of this concept, George S Clason put a figure of 10 percent to it. Is this figure still valid? We will find out as we go along.
Despite all the gyan (wisdom) that I have given you, starting to save from the first pay check may still appear to be a painful affair. I will strongly recommend that you to watch a short movie on YouTube which explains the concept of ‘Save more Tomorrow’ (SMarT)6. The concept is evolved by Shlomo Benartzi from the University of Chicago and revolves around the fact that we all find starting to save today too painful but won’t mind doing so from next month or from the next pay raise. It is a short 18 minutes movie. Do watch it. The link is provided below.
https://www.youtube.com/watch?v=gzcw_02ZB1o
Key Takeaways
Pay yourself first is not depriving oneself of good times in the present; it is an insurance for guaranteed good times in the future by creation of a ‘money machine,’ which will keep paying you without work.
The strategy has to start from the first pay check onwards, lest one gets comfortable with that additional money and increases expenditures.
One has to establish a Spending Investing (SI) balance in life because with that balance all the needs and wants of life can be fulfilled. SI balance, incidentally, is our very next musing.
Please read or listen to ‘The Richest Man in Babylon’ and ‘The Automatic Millionaire,’ both wonderful books on personal finance. Also, see the video on ‘Save more tomorrow’ on YouTube. The links are provided below. I’ll keep sharing more such resources with you as we move along.
https://www.youtube.com/watch?v=qIWwtm5BBGY
https://www.youtube.com/watch?v=A8Nx6xZemG4
MUSING 4: SPENDING INVESTING (SI) BALANCE
“Life is a balance of holding on and letting go”-Rumi.
“The key to keeping balance is to know when you have lost it”-Anon.
The two quotes above sum up what I intend covering in this musing. Life is all about balance—as students, it was about “study and play”, as adults it is about “work and life”; even to remain healthy it is about a “balanced diet”. Like a balanced diet must contain protein, carbohydrates and fat, a balanced financial life must also address your needs (protein,) your saving
s (fat) and your wants (carbohydrates.) These three ingredients finally translate to spending and investing in life—spending to keep you healthy in the present and investing to keep you healthy in the future. Too much of indulgence in the present will adversely impact your future and too much of future consciousness will rob your present of the fun that you so richly deserve. After all, how long can you go on eating sprouts and boiled vegetables but at the same time how long can you afford to have a fat-rich diet?
Translated to our financial health, what should be our ideal balance? Let me introduce you to the 50:30:20 Model7 which is extremely doable due to its simplicity. It not only allows you to put together an optimum SI balance but also acts as a fitness checker as you go along major milestones in your life like marriage, childbirth, retirement and so on. The model has been beautifully explained by Elizabeth Warren and Amelia Warren Tyagi in their book ‘All Your Worth,’ another one of my recommended books.
So what is the 50:30:20 Model? Simply stated, one should limit one’s needs to 50 percent and wants to 30 percent of take-home pay (post-tax and mandatory deductions.) The balance 20 percent should be saved (read invested.) It is an extremely simple concept and applicable to everyone at any level of earning or stage of life. Of course, these are rules of thumb percentages and may undergo changes depending on specific situations, which are well covered in the book. What remains to be defined, is what constitute ‘needs’ and ‘wants?’ An extremely profound question whose answer may vary from person to person, but some guidelines could be laid down.