Money 101 revisited: There is more to life than just money

So far we have covered most of the basic concepts including making personal balance sheet and Artha Chakra, or Wheel of Personal Finance, and we are well equipped to jump into devising investment plan. But before we do that, I want to revisit some of the thoughts from the first article: in our quest to create wealth, we shouldn’t ignore our health and happiness. In India, we culturally condemn wealth though personally we aspire to acquire it. As Diwali, the festival of lights when we worship goddess of wealth Lakshmi, is around the corner, it is apt to discuss this contradiction.

Ancient Hindu philosophy discusses four puruṣārtha (पुरुषार्थ) or efforts in life: dharma (धर्म), finance (अर्थ), pleasure (काम), and spiritual liberation (मोक्ष). So money’s importance was well recognized even in ancient time. Culturally, we seems to have misunderstood the teaching of having a sense of detachment from wealth, and a balanced approach towards all aspects of life including money, as condemning wealth. On the other hand, we seem to have embraced greed (chasing maximum returns, recent innumerable scams), which actually we should have condemned. For example, consider following Sanskrit śloka:

चला लक्ष्मीश्चला: प्राणाश्चलं जीवित-यौवनम् ।
चलाचले च संसारे धर्म एको हि निश्चलः ॥

It means: wealth comes and goes, youth and life leave living beings; in this world of coming and going, only dharma is intransient.

Notice that it doesn’t say money is evil, it just says that money is transient. Actually it says that even life is transient, so does that mean we shouldn’t value our life? It merely teaches us to have broader perspective, and encourages us to follow dharma. I take it as looking at money as just a tool, means and not an end; that money is important, but net-worth and self-worth are not same thing; and that ethics, health, happiness and wealth, all are essential for a fulfilling life. James Altucher has written a nice article on taking care of physical, emotional, mental and spiritual well being.

Let me repeat the foremost principle of my finlosophy: by all means, be prudent about money and respect it; but maintaining a certain level of detachment from it helps in setting and pursuing goals that give meaning to the life. There is more to life than just money. Without this context, the passive investment philosophy of asset allocation and rebalancing I practice in a detached, systematic, methodical way will not make sense. Now I think we are ready to look at investments.

Personal Finance 102: Manage by Method, and not Madness

Many people look at financial advisors and stock markets, be it at Wall Street or Dalal Street, with apprehension if not outright suspicion. After all, events like 2008 financial crisis, Harshad Mehta scam, Ketan Parekh scam have adversely affected so many lives, and our regulators RBI, SEBI and IRDA keep coming up with rules to curb one financial malpractice or other.
I have seen some financial advisors making sale pitch: we will make a financial plan for your life events and execute it, you don’t need to know about investing, you just give us your money and enjoy your life. Well, guess what, if I know or learn investing, how will Mr. Advisor make living? Anybody suggesting me not to learn it, I see them as someone perpetuating financial illiteracy, and evidently self-serving in this case. I run away from such advisors. Financial literacy helps me in asking right questions, not be drowned in jargon, distinguish good advisors from bad, and evaluate their performance.
I also noticed some financial advisors focus solely on investing and returns. Sadly, most of the time, I hear people talk about investments: do it to save tax, or only fixed deposits because market is like gambling, or life insurance policies are best investments, or at another extreme, obsession with stock tips and day trading while working on a fulltime job. This is madness! Investing is just one aspect of personal finance. I suggest methodically spinning Artha Chakra, or Wheel of Personal Finance.

Evaluate Finances: Evaluate your current financial state, know your net worth and cash flow, because assets are created by wisely investing saving surplus. Review results of your existing financial plan and progress so far, check if it has been working as per expectations.
Cover Risks: This is often ignored, but is very important. Set aside contingency funds in a low risk instrument (e.g. fixed deposit) to cover 6-12 months of monthly expenses including loan EMI payments. Insure your assets – life, health, house, car etc.
Identify Goals: Find out what are your short (up to one year), medium (1-2 years), and long term financial needs. Needs will be different at various stages of life. For example, one might seek growing and accumulating the investment corpus during working life, but regular income during retired life. Goal identification will help in deciding suitable investments and their durations.
Revise Plan: Devise a plan if you have none, or revise your existing plan if required. Money you need in short term should be kept in low risk instruments such as fixed deposits. For medium term needs, start systematic withdrawal, say 12 installments spread over 12-18 months, from existing investments to low risk instruments. For long term needs, understand your risk profile to compare and pick suitable investment instruments; and exploit power of compounding and use time value of money calculations to figure out the amount you need to save and invest.
If you can’t meet some of your needs through savings and investments (typically for buying big ticket items like a house), you might want to evaluate the loan amount you need to borrow and whether you can afford it. If you decide to borrow, you will need to calculate EMI payment amount and incorporate it in your saving cash flow computations.
Execute the Plan: Unless you act on your plan, exercise so far would be utter waste. So execute your plan with discipline. Periodically (say every 6 or 12 months), go back to first step to review results and progress.
What is your take? Do you follow a method, or there is method in your madness? Let me know through comments.

Making Personal Balance Sheet

You would have heard about business and companies maintaining a balance sheet, which provides them a snapshot of their financial health. A practice that is good for businesses is also useful for personal finance. In fact, you just being aware of your assets, liabilities, net worth, income, expenses, and savings can help you in assessing an opportunity better; and you can make financially informed choices about investments, expenditures, and job changes. If ever you start a business, to the very least, it will help you in not being intimidated by business balance sheet as well.
I will go as far as saying that personal balance sheet is the most basic tool, and without its assistance, it will be hard to assess how well or bad your finances are doing. No matter how fancy the name personal balance sheet seems, it is actually very simple. And by the end of this article, you will master it.

Net Worth

Net Worth
= Assets - Liabilities

There are two parts of your overall finances: what you own (your assets) and what you owe (your liabilities). Net worth is nothing but the difference between these two. Simple!
You have to just list all of your assets (e.g. cash, fixed deposit, provident fund, bonds, stocks, gold) and all your liabilities (e.g. various loans, credit card balances), and your balance sheet is ready! Here is a sample.

Savings

Savings
= Income - Expenses

Once you have made your balance sheet, you should figure out your yearly cash flow. It also has two parts: what you earn (income) and what you spend (expenses), and the difference between the two is called cash flow or savings. Again, simple! If your cash flow is positive, your net worth will increase over time, else it will decrease.
You have to list all your sources of income (e.g. salary, interest, dividends, rent, business), and all expenses you incur every year (e.g. monthly expenses, loan EMIs, kid’s school fees, travel, house maintenance, dresses and other purchases), and your budget is ready! Here is a sample

Here is the final take away:

Your budget should be positive cash flow machine. Generate saving surplus by improving income and controlling expenses. Invest that surplus wisely to create assets and increase your net worth.

Making your personal balance sheet listing all your assets and liabilities, helps in devising a financial plan and investment strategy that suit your needs
What do you think? Is it simple enough? Too cumbersome? Have any tips on managing it? Please share it in the comments.

Time is Money: Compound Returns, Present & Future Value

One specific feedback I received on my previous article on power of compounding is that the formula for compound rate of return is not obvious in first glance, and I could have done a better job of explaining two components of the formula: principal invested every year, and each of this principal compounding over different period of time. It is a valid point. In my defense, I didn't want the core message of that article to be drowned in the math. The message was that even a small amount invested every month at small rate of return, over a long period of time, becomes pretty big; and that my finlosophy can be useful for passive investor who are disciplined but not necessarily financial savvy.

But the point is valid: basis of the formula is not obvious. I take it as an opportunity to not only explain the formula, but also explain common financial terms and Excel functions.

Formula for Compound Rate of Return

Say you invest a principal amount P at the beginning of each year for the next n years, and you earn r rate of return. We want to develop the formula for computing the accumulated amount A at the end of n years.

Let's see first what happens to a single investment of amount P. Say you had invested P at the beginning of the year, so at the end of the first year, the simple interest on that amount will be P * r, and the accumulated amount will be P + P * r, or P * (1+r). The idea of compound interest is that at the end of a year, the interest also earns interest for the next year just like principle. It is like accumulated amount of P * (1+r) has become principle for the next year. So at the end of second year, the accumulated amount will become P * (1+r) * (1+r) or P * (1+r)². And at the end of n^th year, the accumulated amount will become (1+r)ⁿ.

Now, let's consider what happens when you invest P every year for n years. The amount invested at the beginning of first year remains invested for n years, the amount invested in the second year remain invested for n-1 years, and so on, till the amount invested in the last year remain invested for one year. So the the total accumulated amount is:

A = P * (1+r)ⁿ + P * (1+r)^n-1 + ... + P * (1+r)² + P * (1+r)
= P * (1 + r) * { (1+r)^n-1 + (1+r)^n-2 + ... + (1+r) + 1 }
= P * (1 + r) * ((1 + r)ⁿ - 1) / r

This is the formula I used in the previous article.

Present Value & Future Value

Basic concept is that the value of an amount depends upon when you receive or pay it. A thousand rupees today are worth more than a thousand rupees one year later. In its simplest form, relation between future value (FV) and present value (PV) is like the formula for compound interest:

FV = PV * (1+r)ⁿ

Typically a financial transaction has multiple payments or receivables over a period of time. Depending upon specific case, this basic formula can be applied for each payment to arrive at the formula for that specific case (like I did in previous section for a specific investment example). However you don’t need to work out these formulas, and instead the Excel functions of FV and PV suffice most of the common scenarios.

Another common term used is Compound Annual Growth Rate (CAGR), which is nothing but the r in the formula above:

CAGR = r = (FV / PV)^1/n - 1

Since we are at it, let’s also discuss Net Present Value (NPV) and Internal Rate of Return (IRR). In the formulas above for PV and FV, as well as in their Excel functions, principal amount P is constant. For example, amount P is assumed to be invested every year in formula A = P * (1 + r) * ((1 + r)ⁿ - 1) / r. However this assumption is not always valid. Say, you are making an investment and expect variable payment amounts in future, and you want to find out whether the invest makes sense. One way to compare is to find net present value of all expected future payments and compare it with the amount you are investing. For future payments (FV₁, FV₂, ..., FV_n) at the end of each year, Net Present Value at r rate of return will be:

NPV =

n ∑ i = 1

FVi —————— (1+r)i

Again, you don’t need to encode this formula, and instead can use NPV Excel function.

However, most of the time, you know upfront investment and payouts over a period of time, and you need to compute what is the Internal Rate of Return (IRR). To me, IRR seems same as CAGR. I don’t know for sure, but I think term CAGR is typically used when returns are left untouched with the principal to accumulate over a period of time, while IRR is used when there intermediate payouts spread over the course of an investment. If payout amount is at regular interval, you can use IRR Excel function, otherwise you can use XIRR Excel function.

Hopefully this article has explained the math behind the compound rate of return, and various terms commonly used in financial discussions, personal finance planning, comparing asset classes, and evaluating investment strategies. It also introduces useful Excel function to compute these values. Do you use Excel for such computations? Do you have other useful functions that you commonly use? Please let me know through comments.

Personal Finance 101: Power of Compounding & Discipline

Objective of personal finance is to have money for your needs and desires at various stages of your life. To achieve that, you should determine your financial goals and the timeline for achieving them. In this game, power of compounding is your friend; tax and inflation are your foe. Let’s understand it with a concrete example.
Say, at present you are 28 years old, and by the time you turn 58 (i.e. 30 years down the road), you want to have a retirement corpus of ₹1 Crore (₹10 million). So your financial goal is to accumulate ₹1 Crore, and timeline is 30 years. Will you believe if I tell that you can achieve this goal by investing just ₹10,000 every month in something that earns you post-tax returns of only 6% per annum? No? Neither did I when it first dawned on me. Here is the formula for compound rate of return: A = P * (1 + r) * ((1 + r)ⁿ - 1) / r

Principal amount per year, P = 12 * 10,000 = 1,20,000
Annual return rate, r = 6% = 0.06; 1 + r = 1.06
Number of years, n = 30
Accumulated amount A = 1,20,000 * 1.06 * (1.06³⁰ - 1) / 0.06 = 1,00,56,201.

The point I am making is that even a small amount invested every month at small rate of return, over a long period of time, becomes pretty big.

Power of Compounding, at return rate of 6% per annum

You can play with P and r to get a sense of power of compounding. Say, if you had only 15 years (instead of 30) and invest ₹10,000/month, you will get only ₹29,60,703. Say, if you invest ₹10,000/month for 15 years, and then don't invest anything for next 15 years, you will accumulate ₹70,95,498.
Important take away is: time is money. Utilize power of compounding: start early, have discipline of investing regularly.
So what about inflation? If you were 58 today and retired, you think ₹1 Crore were good enough. But 30 year down the road, inflation will eat away a big chunk of purchasing power of this amount. One way to deal with it to modify your goal: earn a post-tax return of 6% above inflation (i.e., if inflation is 8% in a year, required return is 14% for that year). In future articles, I will use historical data and investment approaches to demonstrate that it is not so hard to achieve it over a long period of time.
Recap: Define your financial goal (for example, accumulate retirement corpus of ₹1 Crore, inflation adjusted, in 30 years). Use power of compounding and come up with an action plan (for example, invest ₹10,000 every month in something that earns post-tax return of 6% above inflation).
If you notice, unlike many targeting super-high multi-bagger returns from stock market, I am discussing only moderate returns (6% above inflation). It is important to explicitly state that finlosophy I follow is not for everybody, it might be useful only for passive investors. Let me specify what I mean by passive investor:

• you are a finance layman, investing is not your bread and butter, you practice some other craft/profession to make your living
• you don’t want your money to remain idle and inflation to erode its value, you desire your money to work to meet your financial goal
• you can not spend a lot of time everyday monitoring your investment, you want only a little time overhead, say 3-6 hours a month.

My goal in future articles is to explain, in simple layman terms, basic finance concepts needed for personal finance planning; to demonstrate passive investment approach and its outcome with help of historical data; and to give simple tools to help executing these approaches.
Does it make sense to you? What are some of your financial goals? How do you plan to achieve them? How much time you spend monitoring your personal finance? What tools do you use? Do let me know in comments.

Money 101: Earn, Save, Budget, Invest, Loan, Insure, Give

What is money? We all use it, we all want it, but what is it? To put it simply, money is a medium of exchange for goods and services. Personal finance is all about having money to pay for goods and services you need or desire in your life. Let’s start with understanding various activities related to money.

Earn: You can earn money by manufacturing goods or providing services that someone else is willing to pay for.

Spend / Save: Spending is the easiest thing about money :-) In modern economy, everyone seems to be out there with sole purpose of selling you something, you can spend your money to buy whatever you deem fit. Saving is the other side of the same coin: you can save either by not spending or spending less. For example, if you can negotiate a lesser price for a purchase, you will save some money.

Devise a Budget: You should create a budget so that you are aware of your earnings and expenses. A budget plan helps to save for major future expenses such as buying a car or house, children education, and your retirement. Your budget plan should be such that your earnings are more than your expenses. The surplus is called savings. First, you should set aside contingency funds. Life has a uncanny ability of throwing surprises. Pleasant ones are nice, it is the unpleasant one that you need to set some money aside for. It is a good idea to have a contingency funds to cover your 6-12 months of living expenses. After setting aside contingency funds, the savings can be invested to grow and meet planned future expenses.

Invest: Another way of earning money is by investing and making your money grow. There are several kind of investments such as equity, debt/bonds, real estate, gold. Each of these differ in risk and returns. We will get into details in future articles.

Borrow: If you do not have money, you can borrow it from someone who has it and is willing to lend it to you. At the end of this transaction, person who receives money has an outstanding loan (or debt or mortgage), which is an obligation to repay the loaned amount, called principal, along with agreed upon additional amount called interest. You should be cautious in taking debt because mindless piling of debt obligations will certainly cause serious troubles later. You should not accumulate debt that you can't repay from your income. Usually taking debt for creating (potentially appreciating) assets is sensible but taking debt for your daily expenses or consumption is a bad idea.

Insure: You need to insure various assets, such as life, health, car, house to cover the risk of loss and damage from unforeseen and unfortunate accidents and incidents.

Give: Last but not least, if you have done well and have more money than your needs, consider donating to worthwhile causes and charities, and helping those who have not been as privileged and fortunate as you. One thing is certain that when you leave this world, you will not be able to take your wealth with you. At some stage, you might want to look at estate planning and creating a will for the wealth you will leave behind.

In future articles, various aspects these activities will be covered in detail.

In your quest to create wealth, don’t ignore your health and happiness. Equating self-worth with net-worth is not wise. After all, wealth is just a tool, albeit a very powerful one. From my personal experience I know that its lack can be a serious hindrance and how its presence can help. But I have also learnt what its absence can’t do: it can’t deny you your destiny, it can’t take away your will to make something meaningful out of your life. Wealth is just a means to an end called life. So by all means, be prudent about money and respect it; but maintaining a certain level of detachment from it helps in setting and pursuing goals that give meaning to the life. That is the foremost principle of my finlosophy.

Make all you can, save all you can, give all you can. -- John Wesley (Sermon 50 "The Use of Money" in The Works of the Reverend John Wesley, A.M. (1840) edited by John Emory, Vol. I, p. 446)

What is your money philosophy? Please share your thoughts in the comments below.