We all have heard the term personal finance & how it is more about the person than about the finance. We also have been advised time and again by friends & family to take care of personal finance. There is also a general consensus that nobody teaches personal finance, you have to learn it. But to learn, you must know, “What is personal finance?”
“Well, it’s personal aaaannd it is about finance!”
It is difficult to explain in simple words as personal finance encompasses a host of things. So, we’ll take the help of Milton Friedman, a Nobel laureate who was also an American economist & statistician.
To understand personal finance, in the second part of our Samadhana Series on Financial Independence, we will understand it’s basic tenets i.e. the principles!
A fun fact is, principles are mostly discovered, they are never invented. Meaning, you don’t define personal finance for you, rather you find out what it means for you!! So, these basic tenets have been discovered by people over the years & they will guide your actions & behaviour towards money! Let’s look at these one by one
- Know your income!
The first basic principle is how much income you earn? Simple isn’t it, the monthly paycheck. But, it’s not so easy for our friends who have a business. They don’t have a regular paycheck, rather the payment terms depend upon the product, the service and the industry. So, in short they need to do a little more maths to find out how much they earn.
Why is knowing your income important?
Because, income is the fuel of the vehicle of your personal finance.
- Budget your expenses
What is budget? John C. Maxwell, a brilliant American author tell that:
Knowing your expenses helps you understand how much & where your income goes. If you spend too much, you may need a higher income or vice versa, if you earn more, you can afford to spend more..
To know your expenses, you need to budget your spends (the Action). Budgeting means, to be conscious of the expenses & record them over a period. Then segregate them into different buckets – Mandatory, Essential, Discretionary etc. Gradually, you will know & understand your spending patterns. Budgeting can help you curb the unnecessary / wasteful expenses. It also helps you be aware the next time you swipe your credit card (the Behavior).
A fun fact here! Do you know the shopping apps like Amazon & Flipkart know your spend patterns, what you like, & what you are most likely to spend on.. Really? Yes, that’s how they recommend you products & advertisements of products.
- Inculcate the Habit of Saving
Savings means you don’t spend your entire income today, for the sake of tomorrow! You keep away a certain portion of the income for your future. The money saved can thus take care of:
- Big spends e.g. a vacation
- Investments for future e.g. higher education
- Help you out in emergencies
- Pre-pay some debt
A high savings rate is essential, as it secures your future. Aim to have a savings rate upwards of 40% of your monthly take home. Cutting down on discretionary expenses is the best way to increase your savings. No-doubt it’s prudent to inculcate the saving’s habit at a young age.
If income is the fuel of the vehicle of personal finance, then savings are the mileage it. Increase in savings, increases the mileage of the vehicle. The ultimate destination of the vehicle is to be wealthy!
George S. Clason in his brilliant book “The Richest Man in Babylon” says:
So, you save to ensure a better future. However, do you know, the most certain aspect of the future is the uncertainty! Hence, we move to the next principle…
- Save for the Rainy Day Even When the Sun is Shining
An uncertainty is an unexpected event for which you are not prepared, neither mentally nor financially. You may be well-off now, but you never know, what shape & size an emergency take. An emergency fund is meant to cater to such situations. Say, your primary vehicle of commute breaks down! You need to repair it urgently as your income source depends on it. The money kept aside for such unseen event is an emergency fund. Emergencies could be of different types: Losing the job, Pay cuts, Medical emergency, a sudden big expenditure.
See the image below to know, how the pandemic led people to dip into their emergency funds.
The idea of an emergency fund is to ensure money is accessible as quickly as possible. The emergency fund would take care of your mandatory & essential expenses in case you lose your income source. Such a fund ensures, you don’t need to borrow from your friend, family or a financial institution (e.g. banks).
So, what is the unseen advantage of an emergency fund? It protects you from unnecessary debt & it also protects your investments from liquidation in case of an emergency.
Talking about protection, leads us to the next principle…
- Protect your Savings & your Wealth!
If I ask you what is the most precious thing you have, I am sure people, possessions & so on, might come to your mind. However, the most precious thing is life & the next precious is probably your health! A life insurance is protection against the financial loss that results, if you lose your life. So, it effectively protects your dependents from the financial calamity that could incur, if you are no more. Whereas, health insurance protects you against a financial loss in case of a major surgery, hospitalisation etc.
That’s not all, there are insurances to protect your finances, in case the house you live in catches fire, the laptop you work in is corrupted by a virus or the vehicle that you drive suffers an accident. Insurance serves the purpose to protect your savings & wealth against such life-changing events.
An insurance company is liable to pay you, in case you file a claim in the event of such unforeseen circumstances. Remember, it takes only one visit to a hospital to make you realise the tremendous drain on your finances. So, health insurance is the first & foremost insurance that you need. Life insurance is necessary for your dependents. But always remember the golden rule: “Insurance is protection & not an investment!”
- Financial Goals
Financial goals are targets that you need to work towards slowly but surely. A clarity about financial goals is of utmost importance, as they provide the necessary clarity of savings & investments. Know the goals, estimate the amount of money required & tenure available to achieve the goal. This automatically guides the return expectation & the investment product. However, first & foremost is to set realistic goals!!
Goal based financial planning is essential, as it helps to build a portfolio of investments tailor made for your goals. Moreover, each goal needs different capital allocation & thereby has different return expectations. Goal based financial plan drawn by an experienced & un-biased advisor can help you achieve the goals with ease.
Financial goals can be classified into buckets of short term, mid term or long term. Goals change & it’s absolutely necessary to understand changing requirements of existing goals or to add new ones. An advisor can help you map out your financial goals, help you choose the right investment to achieve them & tweak the investments based on the changing nature of goals.
- Don’t just save. Invest, but… Invest with Caution!
A job or business is one where you work to earn money. Investment is where the money works to earn you more money. However, understanding the returns is not enough! One must also understand the risks involved in the investment.
As said by Warren Buffett:
“Risk comes from not knowing what you are doing.”
Hence, never invest money based on hearsay or recommendations. Ensure, you know where you are investing. An investment is classified as per the different asset classes such as, equity, debt, gold etc. Multiple products are available to invest in each asset class. Mutual funds, ETFs, PPF, national savings certificates, bonds are some names that you are aware of. To invest in any investment product, it’s important to understand the underlying asset class. This will automatically answer all questions about the risks involved, the return expectations, the duration required etc.
Needless to say, a higher savings rate can translate into higher investments.
- Maintain a Good Credit Profile
A credit profile is an ignored aspect of personal finance. A credit profile from a personal finance perspective is the balance between the money you owe & the money you earn. A loan is a financial obligation on you to repay the amount along with it’s interest. A larger EMI will strain your finances, hence it’s prudent to always borrow within limits.
A debt-free life is a stress-free life, however certain situations in life require a loan. Say buying a home. Take on debt when absolutely necessary, but repay them when you have enough cash. Remember, if high debt can bankrupt a business, it can bankrupt you too!!
- Know your Taxes & Plan your Tax Saving Investments
From childhood till youth we learn to be able to earn. We don’t need to learn to spend. However, seldom do we learn how much we are taxed. That is because taxes in the initial years of earning do not bite you, as the income is below the taxable limit. However, once you reach the higher tax slabs, taxes take away a big chunk of your income. That is when you scramble to invest in some tax saving instruments. Just like my friend Vinay, who buys some dud policy every February just so he can save taxes!
Here’s what you should do. Know the ways to legally take tax deductions. Opt for tax saving instruments & invest in them in a regular fashion, right from April and not in the fag end of Feb & March. Think of tax deductions & tax saving instruments as another opportunity to invest.
- Retire with an Income, not with an Age!
Retirement years should be stress free. Imagine worrying about paying your bills or cutting down lifestyle in retirement. If you cannot imagine that, then it’s better you invest for that. Retirement planning is necessary to ensure you have enough to survive without an active income. The earlier you start, the better you will be off.
A retirement plan will give you an idea, the kind of lifestyle you can expect to live post retirement. It will tell you how much corpus you need and the investment required for the same. Our aim is to not be forced into retirement by age or inability, but ease into retirement with income & stability! Another exciting part is that you can retire on your terms, & pursue your passions freely!
So, my dear reader, personal finance means multiple things for multiple people. However, the above discussed basic tenets are meant to create a solid foundation for your personal finance. The specifics will vary, after all it’s personal, yet we have laid the blueprint for you. So, what are you waiting for? Let’s get going & travel together on this journey of personal finance.
We at ZenNivesh aim to handhold you on this journey & be your friend, philosopher & guide! Stay tuned for more such articles, that will take you deeper in every tenet of personal finance discussed above and much more!