Money Wise: Aam Aadmi's Guide to Wealth and Financial Freedom

by Sharath Komarraju

Consuming is not unhealthy – as long as you know your financial limits.

by Adam Smith, is that barter was the first monetary system, but since it did not have what is called the ‘coincidence of wants’ – that is, each of the two parties having what the other wants – it made trade so difficult and cumbersome that standard units

of account, when discovered, made themselves indispensable.

The philosopher Aristotle said that anything could be used as money, as long as the

participants in the trade are in agreement about its value.

trade. He said that money should satisfy the following four characteristics: It must be durable. Money that fades or corrodes or changes form over time will not work as a medium of exchange. Of what use are the feathers that I gave you yesterday if they break tomorrow? It must be portable. Money should be easily handled, and have high worth packed into small, pocket-sized units. This is one reason why we don’t use oil as money. It would be rather inconvenient lugging around a barrel with you wherever you went. It must be divisible. We should be able to break down money into smaller units, where each unit is indistinguishable in

value from all the others. For example, a ten-rupee note in your pocket is exactly the same, value-wise, as a ten-rupee note in mine. Incidentally, this is one reason why we don’t use real estate as money: because no piece of land is exactly of the same worth as another. It must be a store of value. This is perhaps the most important characteristic of all. Money should have intrinsic worth which stays the same over time. If you think of our trusted ten-rupee note, cast your mind back to your childhood and ask yourself how much ‘stuff’ it could buy. Does it have the same purchasing power today?

As long as the fiat money system persists, we will continue to see a devaluation of the purchasing power of our paper currencies.

Inflation is therefore a tax on the poor in favour of the rich. And governments are able to play this game, again and again, only because of

their monopoly over the printing presses.

The function of the Reserve Bank is two-fold: price stability and maximum employment.

The interest rate is often used as the knob that controls inflation in the economy: when rates are kept low, it spurs a lot of lending activity, people spend more, and prices go

up. When rates are hiked, lending slows, people spend less, demand for goods goes down, and prices go down.

So rising prices are a symptom of inflation. The

cause of inflation is the expansion in the currency supply, which governments carry out periodically.

However, this is not the only way in which money comes into existence. This is how only the first level of money is created, right at the top (and suitably it’s called M0 – read ‘M Zero’), but there is also a second, lower level, where, once again, money just springs into existence out of thin...

This process of keeping only a fraction of deposits in reserve and lending the rest is called ‘fractional reserve banking’.

As a side note, this is why bankers love collaterals, and prefer to give house loans at comparatively low interest rates, because they know that even if you can run, the house cannot. The amount of risk the banker carries is low. But in case of credit cards and personal loans, because the risk of default is higher, the rate of interest is higher.

Growth is to be a net producer of value – which means that you produce more value than you consume.

Method 1: Calculating ‘Forward’ Write down, in current rupees, your expected annual expenses after retirement. Note that this will be an estimate. What most people find after they retire is that some of their expenses (like food, travel, children’s education, etc.) have reduced

while other expenses (like health care) have gone up. A good practice is to assign a percentage figure that you can apply against your current annual expenses. For example, my retirement annual expenditure will be 50 per cent of my current annual expenditure. The higher you make this percentage figure, the more conservative your estimate. As a rule of thumb, go with a percentage figure of 100 per cent, that is, you’re assuming that after retirement, your expenses will be the same as they are right now. Write down, in number of years, the amount of time you expect to spend in retirement. For many of us, this will be around 20-30 years. But if you plan to become financially independent earlier in life, and if you hope to retire early, enter the figure that is right for you.

Multiply the annual expenditure figure that you wrote down and multiply it with the number of years of expected retirement. This final number will be the total amount of money that you will need to accumulate for your retirement. Note that since we haven’t taken inflation into account, you should increase the sum by the inflation amount every year. So if you calculate your target retirement corpus as two crore today, you should remember to increase it by the inflation number every year from now. So next year around this time, your target will be 2.2 crore (assuming 10 per cent inflation), then in the year following that, it will be 2.42 cror...

Method 2: Calculating ‘Backward’ This is a more involved calculation, but also more accurate, so even if you don’t understand all of it, follow the steps with a spreadsheet in front of you. As before, write down, in current rupees, your expected annual expenses after retirement. Use the same guidelines that were laid out in Method 1. Write down an annual rate of return that you are confident of earning from your corpus. (For simplicity, enter 12 per cent for now.) Write down the expected rate of inflation throughout your retir...

real rate of return from your corpus. In this example, it will be 12 – 10 = 2 per cent. The idea now is that since you know that you can earn a real return of x per cent on your corpus, you can theoretically just skim the excess x per cent off the top every year for your living expenses and keep the corpus untouched. That way, at least in theory, your corpus stays undiminished forever, whether you are retired for ten years or a hundred. An example: Say my corpus is worth five crores. My estimated rate of return is 12 per cent and my estimated inflation figure is 10 per cent, which leaves me with a real rate of return of 2 per cent. So by the end of Year 1, my c...

remaining 5.5 crores I keep it as my corpus for the next year. The next year I do the same calculation, taking out 2 per cent and reinvesting the rest. Now we get to the business of actually calculating our corpus figure. Divide your annual estimated expenses (from point 1) by your real rate of return (from point 3) and you will get your corpus figure. Example: If my estimated real rate of return is 2 per cent and I expect my yearly retirement expenses to be 1...

The philosophy behind paying yourself first is simply that before you pay anybody else in your life with your money, you pay yourself.

what should be our first priority on our road to wealth? To tackle debt, of course.

Use the money in your fattening purse to pay down your debt, the one with the highest interest rate first, and keep paying it until you’re free of all debt that is outside of your home.

Whichever strategy suits you, as long as you commit to it, you will be fine. As long as you follow the first principle of paying yourself first, this second principle, of using your surplus amounts to pay off debt, will keep going on its own. Depending on how many people you owe, the task may look daunting at first, but you will find that with time, the process feeds on itself, because with each loan you knock off, the payments you have to make decrease, and there is that much more surplus for you to pay away the remaining debts with.

The Emergency Fund

After you’ve paid back all your debts – with the exception of the house loan – common financial wisdom recommends you turn your attention to the emergency fund.

There are two challenges to building an emergency fund that will test you, and if you pass,

will strengthen you for your investing life ahead. The first one, to state the obvious, is to keep up the discipline of adding to it without flagging until the target amount is reached. It is particularly hard in the first few months, where it seems like you’re making a lot of effort for not much reward, but I promise you, it does get easier. You will miss the money less and less, and as you see your fund swell in size, it will give you further motivation to keep going. The second, and in my opinion the bigger challenge, is what you do with the fund once it is full. You get a euphoric feeling that generally accompanies a job well done – do go ahead and pat yourself on the back – and also a bundle of money that will make your eyes light up. This can easily tempt you into loosening your definition of an ‘emergency’. For instance, you may lure yourself into thinking that you really need that new

overseas vacation or that new car, and before you know it, you’re booking your tickets...

A word of caution here, on hybrid accounts that give you both liquidity and high interest: It may sound like the perfect idea, but you may find that once again, you will be tempted to spend a little on comfort here, a little more on another comfort there, and before you know it, you’ve blown up half your fund. So it may be best if you go for a good old fixed deposit, with a strong mental note that the money is not to be touched until an emergency comes knocking.

As a rule of thumb, the absolute minimum that you will need – if you’re an earning middle-class citizen with an average-sized house loan – is health, life, disability and vehicle.

But a word of caution here: we must all remind ourselves why insurance exists. It is to protect us against unforeseen events. It is not an investment product.

So no matter how high or how low your income is, if you make a habit of paying yourself first and keeping yourself disciplined enough not to spend your saved funds, then you will build wealth over time.

There are two measures of inflation: Wholesale Price Index (WPI) and Consumer Price Index (CPI).

A risk-conscious investor must build diversification at multiple levels into his financial life. At the very least, he must aim for

the following two types of diversification.

Diversification of Active Inc...

First, a definition: active income is income that requires expenditure of resources on your part in the form of time and effort. Throughout the course of our working lives, most of ...

Diversification of Passive Income Sources

Again, the definition first: passive income is income that you earn without an expenditure of time and effort. For most of us in India, rental real estate is the one source of passive income that we all relate to.

There are primarily two ways in which a real estate investor hopes to make money. Appreciation or capital gain.

Rental income.

So let’s take a moment to look at the various types of ownership that you can choose as a real estate investor. Leasehold ownership. You can own the structure that is built on a piece of land while the land still stays under the ownership of someone else. Alternatively, you could be on the other side of the leasehold agreement, where you own the land, but the structure built on it is not yours. In this case, there is a lease agreement between the tenant and the landlord, and the rents get revised at pre-agreed times by pre-agreed amounts. Freehold ownership. This is more common, and more easily understood. This means that you own the land and the structure built on it. For instance, if you buy an

apartment, you will be allocated a certain amount of land area, and a certain amount of living space. So you will own a fraction of the land, and a fraction of the structure. All owners who buy an apartment in your complex own similar fractions, and they all add up to a whole.

Its value will never dip to zero. No matter what the economic condition, a piece of land will always have value. A house which people can live in will always have demand (unless it is in a completely dilapidated state that is). This does not mean that you will never lose money in real estate. You can. But since it fulfils a basic human need, your asset will always have some value.