Who Wants to be a Millionaire? Part 1
The eternal dream, the pursuit of happiness (through mountains of cash). After all money can’t buy happiness but it gets you pretty damn close.
This isn’t a love letter to Capitalism and Consumerism (sorry Ayn Rand).
It’s a crash course in everything I have learnt so far trying to ensure Future Avik has food to eat, also known as Basic Personal Finance.
My friend and fellow 30 day writing challenge compatriot Pranjal Kalra has laid down some fantastic first principles here and I intend to build upon them as well as add a little bit I’ve picked up here and there.
Before I start bombarding you with points, what is personal finance?
My favourite definition is “The art of managing your Savings, Investments, Earnings and Spending”
Okay my head is spinning, where do we start?
I’ll go deeper into numbers later in this post (and ones to come). This first bit is to get us comfortable with the basic concepts of personal finance.
#1 SAVE
Morgan Housel, author of The Psychology of Money (read it!) sums it up perfectly by pointing out “Wealth is what you don’t spend”.
That being said, savings are hard, especially when you’re struggling financially (or that new Iphone looks soo soo good).
So how do we solve this probem? I’ll start with a fact will be repeated across this article, Human Willpower is Finite. This is a complex way of saying we have a limited amount of willpower (or f**cks to give).
Since we are clear on this point, how does it help us? On one hand we can try and exercise Monk-level powers of delaying gratification (trying and failing for the most part) or we can take willpower out of the equation!
By automating savings and ensuring that the moment payday comes and your bank account finally has a balance greater than zero, you remove the urge to spend that money.
The golden number is up for debate (20% , 30%, 50%, who knows) but the rule of thumb is at least 20% of your income to be on the safe side. Move it into a separate account entirely, ideally in a different bank, so you won’t get tempted to spend it. (We will discuss investing it later).
This is one of the singular most powerful methods of saving money.
Another important tip here is to avoid the Hedonic Treadmill.
The Hedonic Treadmill is essentially:
Earn More, Spend More. Let me illustrate with some numbers
As you can see, Julius and Brutus (et tu Brute?) start off as colleagues earning the same amount. Having read the same books they both carefully save 20% of their salary.
2021 comes around, Covid has left the planet (wishful thinking) and their generous bosses give them a raise. Julius has been a star performer so he gets a 100% raise, Brutus spent a bit too long sharpening his dagger so he gets a 60% hike (if only this shit was real life!).
Julius rents a bigger house and buys a BMW (because of course!), Brutus gets a new set of golf clubs and calls it a day.
Julius continues to follow his tried and tested method of 20% savings.
Brutus decides to save his increased salary and continue to live without a BMW. Despite earning 25% less than Julius, Brutus saves a whopping 75% more!
This is because he has avoided jumping on to the Hedonic Treadmill.
Simply put, the Hedonic Treadmill is the type of treadmill you MUST avoid if you want to build wealth (as opposed to the one in the gym, which is fantastic).
#2 INVEST
Now we get down to the most confusing part of the puzzle for all of us, what is investing? For the average person (also me before the long stretch in Covid) we would put some money into Fixed Deposits (FDs), buy some ETFs/Mutual funds and feel extremely pleased with ourselves.
This isn’t a terrible approach (there are very few right or wrong answers) however this is kind of the vanilla approach towards investing. Picking safe and fairly common pieces of wisdom without really thinking about a strategy overall.
Before diving deeper into investing, let me first throw in a quote
Compound interest is the 8th wonder of the world (some attribute this to Einstein but it’s unconfirmed).
To understand this better once again we turn to our good friends Julius & Brutus.
Brutus, being the careful saver that he is, decided to invest $500 every month into a good index fund tied to the stock market, returning 7% annually (compounding obviously). He started at 22 and invested till 62, investing a total of $240,500. On retirement, he suddenly found his investment was worth $1,205,297 !! That’s a 398% return on his total investment.
Julius thought about investing and put in $10,000 at 22 into the same fund as Brutus (I don’t know where he got it from, ask him). After that, he meant to get around to investing but bought a Rolex (SHINYYY). Followed by a Maserati, then a boat (Julius is a BALLER). By the time he retired, he realized he had no savings! Then he remembered the $10,000 and checked the fund.
They sent him a cheque for $149,744. That’s a 1400% (rounded) return! If he had invested $20,000 at 22, he would have gotten $299,489!
The point of this rather lengthy example is start investing early! The faster you start, no matter how small the amount is, creates a mountain of cash for you at the other end of the tunnel.
Now that we’ve gotten the most important part out of the way, how on earth do we end up generating 7% returns? (leaving aside Fixed Deposits?)
#1 Index Funds: These are Mutual funds or ETFs (consider both the same for now) that invest in certain stock market indexes on a constant basis. Indexes are nothing but a collection of companies based on various factors (typically capitalization and sector). The most commonly known ones are Standard and Poors 500 (S&P 500) that measures 500 of the largest companies in the US across different sectors or Nifty 50 in India.
These are some of the easiest and most reliable investments to make as historically the largest companies have gotten larger (and the indexes change, adding and removing companies based on performance).
S&P 500 has returned ~10% annually from 1920 till date.
Nifty 50 has returned ~11.1% over the last 20 years.
The easiest way to enter S&P 500 is to buy Vanguard S&P 500
The easiest way to enter Nifty 50 is through HDFC Nifty 50.
#2 Focused Funds: Now we move into slightly more advanced territory (don’t be alarmed!). These are typically funds managed by a variety of Fund Managers, familiar names like Blackstone, Vanguard, HDFC, Axis, Fidelity or newer age Managers like Cathie Wood’s Ark Invest
First off, let’s cover the basics (familiar names). Focused funds have 3 key things you need to keep an eye on. Sector/Theme, Expense Ratio and Historic Returns.
Sector/Theme: This defines the approach of the fund (example DSP Healthcare Fund specifically invests in Healthcare stocks in India & the US)
All public funds are required to make their themes, distribution (large cap, mid cap, small cap), companies invested in and % holdings public.
In effect, this allows you to invest across a sector or theme you like and want more exposure to.
Expense Ratio: Basically this is what the fund managers charge for managing and operating the fund (no they do NOT do this out of the goodness of their hearts). This is an important number to keep an eye on because it tells you how much your actual return is (Fund A returns 5% but charges 1.5%, Fund B returns 4% but charges 0.2%, therefore Fund B is more attractive)
Historic Returns: First off, past performance DOES NOT equal future succes, but it gives you a pretty darned good idea if the fund can make you money or not :P . Funds with a strong historic performance tend to be safer (don’t quote me) as the managers have a solid track record delivering returns.
The attractiveness of Focused Funds is that you can get exposure to sectors you are interested in without having to manage a stock portfolio yourself (fairly painful) and generally generate higher returns than index funds (with more risk of course!)
A couple I am very bullish on are Ark Innovation, DSP Healthcare Fund and FDN Internet Fund. Do keep in mind that Index Funds are riskier, after all,
No Risk, No Reward!
#3 Bonds: Bonds are effectively a loan to companies from the public, with the companies directly paying them interest (oversimplified).
Bonds are issued by large companies (there are a lot of rules to do this) directly to the public (namely you and me) with the promise to pay an annual interest rate.
Why buy bonds? Think of bonds as a fixed deposit with a company. While they will never generate the kind of appreciation you get from stocks, they also protect you from the ups and downs of the stock market and give you
fixed income every year.
Yearly fixed income is very important as we grow older as it gives us guaranteed cash flow (cash money in the bank!!)
#4 Stocks: I had to get to this eventually. This is the kind of investing most people think of when it comes to the stock market and frankly I go on and on about them but let’s keep this brief.
A stock is a small piece of a company. When you buy a stock, what you are actually buying is the ownership of a small piece of a company. This does not mean you own Coca Cola by buying one share, but it does give you certain rights. The one that concerns us now is you have the right to participate in a part of the earnings in the form of a dividend.
A dividend is part of a company’s profit that they decide to give back to investors (such as yourself).
So how do we end up getting Bananas? Oops, I meant, is that how we make money from Stocks? Through dividends?
The answer is both yes and no, but for now let’s stick to no.
One makes money from stocks by buying companies that we feel will keep growing (or just buy Tesla and pray). There are many indicators that will help you figure this out but the starting method is fundamental analysis (no way I can cover this large a topic, read more here).
Once you figure a company will keep growing in size and profit (and therefore value), go ahead and buy some. A safe option here is to regularly buy blue chip stocks, basically large familiar names (Think Google, Microsoft, Oracle, Unilever, 3M, Reliance etc).
There is a reasonable assumption that blue chip stocks will continue increasing in value at a steady rate so your stock will be worth more.
It’s worth mentioning that stocks are profit-on-paper until you book profits (sell the stock) though they are extremely liquid, which means you can sell them virtually instantly and get money in your bank.
#5 Real Estate: The tried and true method of making (or losing) money is buying real estate. For most people that means buying a home and renting it out or living in it (for the high rollers that could mean buying an entire commercial or residential building and leasing it out).
This has been one of the steadiest ways to build wealth across generations as homes tend to appreciate fairly well. It’s worth mentioning though that the way the world is changing today with remote working, real estate is poised to look very different in the years to come.
If you don’t have a pot of gold buried in your backyard to buy a home, you can also choose to invest in a Real Estate Investment Trust (REIT). A REIT is essentially a Fund Manager that buys real estate instead of stocks and gives you a yearly return (part of the rent).
Think of a REIT as the love child of Bonds and Stocks.
#6 Everything Else: I have left this one fairly open ended as everyone has some investments that are unique to them. Julius loves collecting Rolexes (not a great investment), I buy bitcoin (WOOHOO) and invest in startup companies (read more about angel investing here).
Whether you like buying a literal pot of gold (fairly safe store of value so far) or investing in businesses, there’s a whole buffet of options out there to invest in to help boost your returns.
This brings today’s post to an end, we have covered Saving & Investing so far!
I’ll be back tomorrow to discuss Earnings & Spending. I hope you enjoyed this so far, let’s start that pathway to Millionairedom!!!
Additional Reading
- https://psychology.columbia.edu/sites/default/files/2016-11/3.pdf : An excellent research article on delayed gratification and the mental frameworks behind it
- Morgan Housel on the Hedonic Treadmill
- Pay Yourself First
