10 Commandments to Financial Freedom
What is Financial Freedom?
The meaning of the term “financial freedom” could be different to each individual but the broad concept would remain fairly the same for all. It means one has accumulated enough wealth to generate a cash flow such that the financial needs can be met without “actively” earning an income.
However, the world is filled with people with above average income and below average wealth. Many are unable to attain financial freedom their entire life, despite working hard, saving and investing.
So where is the disconnect?
Most of us do not know how to handle our personal finances.
Personal financial management is a life skill, which, like many other life skills, are not taught in the schools and colleges. Even finance professionals lack these skills when it comes to managing their own personal finances.
Managing personal finances is not rocket science. It requires only a basic understanding of the subject and basic math skills. However, the fear of the unknown keeps many from learning these skills.
The 10 commandments in this blog are intended to help anyone to manage their personal finances effectively and build wealth without breaking your bank to acquire a finance degree! Note, these are not just tips but “commandments”!
So, here we go!
- Thou Shalt Respect the Power of Compounding
Money tomorrow is worth less than the money today, due to an unseen factor called “inflation”, which nibbles away at the purchasing power of any currency in the world. Whatever is the cost today, of any product or service, one can be rest assured that it will cost more in the future.
However, the world of finance has an effective antidote to inflation called compounding of returns. Compound interest is where, in an investment, the invested amount earns a return and the return too earns a return.
The power of compounding can be fully taken advantage of when an investment is given a reasonably long time frame to grow. The result from the combination of a long time frame and the principle compounding is formidable.
A simple example will demonstrate the power of compounding. If a person invests 20% of income regularly in any instrument that gives 12% post tax returns, then in ~ 30 years, the returns from this investment would have yielded an amount equivalent to the total income earned by that person during the entire period. This is like having a second income without having to work for it!
Takeaway: Resolve to invest regularly, with discipline, in those asset classes which are expected to provide a return higher than the rate of inflation, and remain invested for a long time period.
2. Thou Shalt Insure and Protect
Insurance is an integral part of any personal finance plan. It should be clearly understood that insurance is only a protection and not an investment. The insurance premium is the price paid for peace of mind. Period. This is all the more true to life insurance.
In the absence of insurance protection, one unfortunate incident can destroy a life time of efforts, dreams and ambitions.
Unfortunately, many do not understand the purpose of life insurance and invest in combo plans that have investment and insurance bundled together. Usually such plans provide low insurance coverage and give less than optimal return on investment. These plans enrich everyone in the value chain except the investor!
Takeaway: Protect valuable assets, including life and health, with plain vanilla insurance. Do not opt for any life plan that offers any return of money on maturity. Ensure that the life insurance value is such that, in the event of any unfortunate development to the life insured, the financial goals and needs of the family can be met.
3. Thou Shalt Invest for Goals
Goal based investing is the only way to invest. Even if you have a piggy bank at home, label it with a goal! And if you have multiple piggy banks, have multiple labels!!
But why is goal based investing such a big thing?
Goals define the target date and target value. Target date defines the time frame. Time frame defines risk profile. Risk profile defines asset class. All the above combined with the target value shows how much is needed to be put away today to reach the target.
So goals define where to invest, how much to invest and how long to stay invested.
Investing without a goal is equivalent to traveling without a destination in mind. You will reach somewhere but not necessarily where you should be reaching!
Takeaway: Write down all your financial goals, including retirement. Categorise them into short, medium and long-term. Start investing against each goal separately in appropriate asset classes.
4. Thou Shalt Not Spend without Budgeting
Budgeting has only one simple objective; how to utilise a finite resource effectively. Budgeting does not mean stinginess and deprivation. Without some form of basic budgeting, no financial plan can ever be implemented effectively.
Budgeting needs only two skills; basic math and the wisdom to differentiate between needs and wants.
Takeaway: Develop a simple spending budget in writing and stick to it. Involve all your family members in this exercise for its success.
5. Thou Shalt Not Borrow to Spend
Unless you want to help the people working in banks to make more income than what they are already making, never take any loan other than a home mortgage.
Borrowing for an expenditure or to buy a depreciating asset (yes, a car falls in this category) is a bad idea. Due to extreme circumstances, if such borrowing cannot be avoided, pay it back as soon as possible. However, ensure that such a need will never arise by creating and maintaining an emergency fund.
Takeaway: Resist the temptation to take a personal loan to fund that dream cruise vacation. Treat the vacation as a financial goal and save for it.
6. Thou Shalt Not be Tempted by Tax Benefits
Tax benefits cannot drive investment decisions. Investments are made in financial instruments that fulfil the needs of a specific financial goal. If tax benefits comes along with such instruments, it is a nice to have.
There are no free lunches! Investments with tax benefits comes at a price. That price usually is either less than optimal return on investment or sacrificing liquidity with lock-in period or both.
Tax benefits have got value only if all other requirements of the financial goals are met by an investment. Of course, go for the cherry; only if you like the flavour of the cake!
Takeaway: Consider tax benefits as the last factor in your decision making process.
7. Thou Shalt Understand Risks
Risk as a concept is not well understood. Investors look for risk-free investments. There are no risk-free financial instruments though many plans are nicely packaged to show they are risk free, when, in fact, they are not. Risk cannot be avoided but can be managed.
I recommend reading my earlier blog on the topic of risk.
Takeaway: After reading the above article, analyse what was your earlier understanding of the risk profile of each asset class and how it has changed with the information from this article.
8. Thou Shalt Buy a Home Only to Live In
Real estate, as an asset class, provide only an average return on investment. Moreover, it is highly illiquid and has ongoing costs (maintenance, tax etc).
Real estate is also a high-ticket investment. Once a mortgage is taken to buy a home, not much cash flow is left to save and invest for other goals.
If one is sure of living long-term in a particular city or location, it makes sense to invest in a home. Otherwise, rent a home.
Takeaway: Do not consider real estate as a financial investment. Treat it like anything else that you would buy purely for its utility value.
9. Thou Shalt Plan for Your Sunset Years
Financial planning for retirement is the most neglected and least understood topic in personal financial planning. Even in the US, the average size of retirement fund is a woefully inadequate US $ 85,821.
(https://www.cnbc.com/2018/05/15/how-much-americans-have-saved-for-retirement.html).
So what are the elements involved in retirement financial planning?
a. Years to retirement from now;
b. Life expectancy;
c. Inflation from now until retirement and until end of life expectancy;
d. Assumption of return on investment in pre-retirement and post-retirement periods;
e. Cost of living for a retired life today, what it will be on the date of retirement after inflation and how it will keep increasing year after year until the end of life expectancy;
Takeaway: Write down each of the above as it is applicable to you. Then assess the adequacy of your current retirement planning.
10. Thou Shalt Not “Do It Yourself”
The best was saved for the last! If this is followed, then the other nine will be automatically take care of!
When we need a haircut we go to an expert. But most of us opt for DIY for our personal financial planning. Or worse, we assume that the sales person selling an investment plan is “our financial advisor” who has only “our interest” in mind!
Many of us could be holding wrong investments. If we go back and see how we got into it, we will realise that, in most cases, we invested based on advice from either non-experts (friends, colleagues etc) or someone who had a conflict of interest (investment sales person).
Do not grudge the fee payable to a licensed financial advisor. Assuming he or she is a good advisor, the payback period for this fee will be 1–3 years or less. Treat this fee as an investment and not as a cost.
How to select the right financial advisor? That will be a topic for another blog!
Takeaway: Engage a financial advisor, who is licensed by the laws of your country to provide personal financial advice. Take an active part in the planning as it is an interactive process.
Conclusion
Reflect on each of the above commandments. Write against each of them your current situation and see where further actions, if any, are needed. If you follow these commandments diligently, several years down the line, when you will be achieving one or more of your financial goals, I am sure you will remember the day when you read this blog post! And drop a “thank you” note to your financial advisor!
