Handling money is not as simple as earning, spending, and saving. There are a few universal principles of money management that must be followed. Each individual is unique, hence one’s way of handling money may not work for the other.
This is where the universal principles become handly. Everyone can follow the principles to devise their own way to deal with their money.
My article aims to structure the mindset of readers in a way that helps them to see money from the right perspective. It deals with the goals, variables, and specifics of how to handle the money well.
We cannot be careless in dealing with money. People who do it have to contend with a mediocre lifestyle. But if you do not want to fall into the trap of mediocrity, better follow the mentioned principles. It will not only help you gain more control of your life (time), but will also help you become financially rich.
#1. Four Variables of Success
To build wealth over time, one must save and invest money. But what is the guarantee of success in investing? We must acknowledge the four variables leading to success to answer this question. The first three are basic, and to an extent within our control. But the fourth one also plays its part. As an investor, knowledge of these three factors will keep us grounded. If we see success, we’ll stay humble. If we fail, we’ll not feel too bad about it.
These are the four variables:
- Skill: There are people who have a natural ability to handle money wisely. But others must build financial intelligence from a scratch. Investing money without the necessary skill is like planning to fail. So, a beginner must learn to invest and then apply the knowledge to use.
- Action: Even the easiest of tasks will remain undone due to inaction. Being skillful will be useful only if those skills are applied to use. An investor must continue to invest money at all times. This is what is called putting money to work. Knowledge about the ways to invest money helps to keep investing all the time. One cannot invest the same way all the time. As situations change, we must evolve and change.
- Risk: While we are investing, awareness of risk is paramount. We must know our risk appetite. We must also be skillful enough to judge the associated risks of the investment we buy. Investing within the boundaries of our risk appetite is the goal. How to do it? By being aware of how to balance the risks and returns.
- Luck: Even if one is able to manage the above three variables well, things can go south. For example, a person who invested in December’2019 was unlucky as COVID struck after that. Businesses were gearing up for revival in Jan’2022, but the Russi-Ukrain war came as bad luck. People who bought an expensive property (in the USA) in the year-2007, feel unlucky even today.
How important is luck in investing?
To a very small extent, the luck factor can be handled by one’s ability to look at the bigger picture. How to do it? By staying informed of what is happening around us. Awareness & news about our city, state, country, world, etc will help. Some knowledge of astronomy might also build a wider perspective.
Why I’m saying this? For example, a person with a perspective who was closely following the news might have had the chance of evading the aftermath of the mortgage crisis, covid, etc. Having said that, our world/universe is too wise & diverse. It will take an act of god to know about all the variables. Hence, humanly it is impossible to fully manage luck.
We may not appreciate the luck factor in investing with a myopic view. Looking at the bigger picture will help us realize how many things are happening around us. In this connected world, one action in Europe might trigger a market collapse in Asia.
As an investor, I’m always aware of these four factors. When things are going in my favor, I appreciate the role of luck. When things are not going in my favor, I know where to focus. I must work on my skills, actions, and risk management to minimize the luck factor as much as possible.
#2. Wealth is invisible
What we see is spending, wealth is always invisible.
We judge people’s wealth by looking at their lifestyles. Holidays, homes, cars, clothes, gadgets, etc are our indicators to gauge wealth. But in reality, these are indicators of spending, not of wealth. We assume that if a person is spending more, it’s an indicator of spare money. But you’ll be surprised to note that, the majority overspend. So, spending is often driven by a bad habit rather than wealth.
Wealth is created by saving.
Here the term “saving” is not used in our normal sense. I’ll explain more.
Wealth can be judged from the size of one’s investment portfolio. The bigger the investment portfolio, the larger the wealth. By choosing not to dilute our portfolio by redeeming (saving), we can become wealthy. The investment portfolio should look something like this, without any tap holes. This way we are only planning to save and not spend.
Saving money in our savings account will not be enough. Use it to buy assets. Kee the assets in the investment portfolio till infinity. This is the way to build wealth over time. It is one of the universal principles of money management.
#3. Investing within the circle of competence
If you will ask Google, where to invest money, it will list down multiple investment alternatives. But unfortunately, it will not be the right answer. The correct answer will be to invest where is your circle of competence.
Let’s understand this from a simple example. Suppose you want to self-drive to reach a destination. The urgency to reach there on time is unavoidable. But that night, you decided to explore a new road. Why? Because it might help you reach earlier. It lead to stress and the whole night you could not sleep well. It leads to further complications.
In investment, it is always better to tread on a known road. This is what is called investing within one’s circle of competence. For the majority of us, our investment know-how is limited. Hence, we must build our circle of competence. How to do it? Start with reading about the basics of investment.
Once the basics are known, delve deeper and research specific topics like stocks, mutual funds, property, gold, etc. The more one will read & practice, the wider will become the circle of competence.
It is a part of skill development as discussed in point #1 above.
#4. Utilize the power of compounding
- Example #1: Investing about Rs.1.4 lakhs in Britannia industries in 2002, would have compounded to become Rs. 1.0 crores today (in 2022). This will happen at a rate of return of about 23.8% per annum.
- Example #2: Similarly, investing about Rs.0.95 lakhs in Bata India in 2002, would have compounded to become Rs.1.0 crores today (in 20 years). This will happen at a rate of return of about 26.2% per annum.
- Example #3: Similarly, investing about Rs.1.51 lakhs in Bata India in 2002, would have compounded to become Rs.1.0 crores today (in 20 years). This will happen at a rate of return of about 23.32% per annum.
These are a couple of examples of investments that have rendered staggering returns over a long time horizon. But both these examples display above-average returns.
In the stock market, a good company can yield between 15-20% per annum returns over the long term. Here are a couple of examples of such companies:
- Example #1: Investing about Rs.3.2 lakhs in Reliance industries in 2002, would have compounded to become Rs. 1.0 crores today (in 20 years). This will happen at a rate of return of about 18.78% per annum.
- Example #2: Investing about Rs.3.15 lakhs in ICICI Bank in 2002, would have compounded to become Rs.1.0 crores today (in 20 years). This will happen at a rate of return of about 18.92% per annum.
What is the point?
The rate of return between 18% to 26% per annum is possible in the stock market. But only good stocks (investments) can yield such returns. Skillful investors can identify good investments. But as important it is to identify good investments it is equally essential to stay invested.
Our investments need time to grow. A good investment staying put for 20 years or more can give above-average returns. This is what is called the power of compounding. It is one of those universal principles of money that gets proven time and again.
Just increase the holding time of your investment and see the magic of compounding.
#5. Remember the 90/10 Rule
An investment portfolio may consist of multiple assets/securities. Out of those only, about 10% will be outstanding performers. The balance will be either the laggards or even the losers. This is a normal portfolio behavior. One shall not panic and feel demotivated seeing many reds. Only a handful of stocks will generate the majority returns. I call them long-term winners (See a few examples stated above).
Here is a snapshot of a typical investment portfolio having a mix of top performers, laggards, and losers.
Our focus shall be on picking these long-term winners. In the process of picking these winners, we may end up accumulating a few bad ones. It will happen, and it’s common even for trained fund managers. So do not worry a lot about those blemishes. But yes, we shall not start picking investments carelessly. Risk management rules and skill development will help.
In order not to get distracted by the low-performing holdings, one must focus on the overall return of the portfolio (portfolio’s averaged returns). In India, if a portfolio is yielding a return of 15% or higher, we can grade it as good.
#6. Invest To Attain Financial Independence
Purposeful investing is sustainable.
When Investments are done just for the sake of doing it renders less utility. Why? Because that money has no purpose, no goal. Hence, as soon as the opportunity comes, it gets spent. Hence, it is always advisable to practice goal based investing.
There can be several smaller goals, but the big purpose of investment and wealth creation shall be to attain financial independence. For me, there are four milestones of life. Every now and then I see this picture in my head to reinstate why I’m doing what I’m doing.
We must invest money to become financially rich. But the road to richness must first pass the milestone of being financially independent. To become financially independent, one must first start generating passive income. When the quantum of passive income becomes greater than the cost of living, the state of independence is reached. After that, every penny of extra income is spare cash. The quantum of spare cash will decide how rich is the person.
What is the takeaway? First, attain financial independence, and only then the process of becoming rich will begin.
#7. Prepare for the inevitable
There are few things in life that are bound to happen to most of us. What are those things? We’ll get married and have a family. Eventually, we’ll purchase a vehicle and a house. There will be costs related to child care and education. We’ll need insurance for health and life. Maintaining a chunk of cash for miscellaneous, unplanned happenings will be required. At the end of it, we’ll also need a big enough retirement fund to support us in old age.
Some of these requirements can be taken care of from the proceeds of our investment portfolio. But a lot of these are extra requirements, like insurance, emergency cash, etc. How to deal with it? Better is to prepare a list of such future financial requirements and start saving for it from today.
It is better to buy insurance as early in life as possible. It is especially true for health and life covers. I’ve written a detailed article on how one can manage the requirement of the emergency fund. Please follow this link to know more about it.
These are the seven universal principles of money management that I found most relevant in the present context. For a beginner, these seven steps might look overwhelming, but remember that personal finance management is complex. But to solve the complexity, you only need to do two things, save and invest. Keep it simple, and just keep doing these two things month after month.
Once you get into the habit of it, structure the saved and invested money with the seven principles of money stated above. A starter will need at least ten years to reach the stage sixth and seventh. So do not stress yourself by trying to achieve things in a hurry. It will not happen. Give yourself time, and things will start to take shape as you continue to save and invest.