Friday, 9 December 2011

Reviewing Our Financial Status

We believe the financial status which we get in society is by the amount of money which we earn. That is only the necessary part of it and certainly not sufficient. We actually get financial status by the amount of wealth which we accumulate and build which can be totally different from the amount of money we actually earn. To understand this concept clearer you decide which of the categories mentioned below you belong to and what your financial status is.

Category I: Spending more money than earning
This is the category of a reckless person who earns a lot of money but unfortunately has negative net worth. This is because he understands the concept of earning money very well but not how to build wealth. This is a category of a person who might have a big fat salary but with it goes a big house mortgage, a posh beach home & costly cars on high interest bank loans along with imported furniture, jewelries, foreign vacations etc financed by credit card. This person never builds wealth. No doubt, he / she earns a lot of money but most of his / her money goes in just paying interest on unnecessary revenue expenditure like foreign vacation or gruesome / bad capital expenditure – those assets like car, beach house which take away money from your pocket or a house which do not put any money in your pocket. He then uses the wealth effect – borrows more against his existing assets to finance further expenses and luxuries. It all goes well till his asset can keep financing his recklessness, the day asset prices start falling, his net worth becomes negative and he tumbles like a pack of cards. People in this category are those who earn a lot of money but have no wealth.     

Category II: The Money Savers
The second category is perhaps the category of the most financially illiterate person. No doubt, he has more wealth than the first category and a positive net worth but the amount of sacrifice which he does for that wealth is much more than what he gets in return. This category person does not know that after the US President Nixon removed the US Dollar from the Gold Standard, money is no longer money but just a “currency”. In essence the US can and actually does literally print “paper money” backed by no tangible asset like Gold. Hence, the money is bound to loose value over a period of time as more and more currency chases fewer and fewer real assets. The person in this category does not understand this basic principle of money. He earns good income and then “saves” all the money in an instrument like a bank fixed deposit. This category person, although earns a “safe” return on his capital, but is at big risk to the financial monsters – inflation and income tax. He pays the highest amount of income tax (depending on his tax bracket but no specific deduction for interest income and hence fully taxable). At the same time the inflation monster eats into his real return over a period of time and makes him poorer and in turn reducing his standard of living. This is the unfortunate category of a person who saves but does not invest and hence subjects himself to the financial monsters of inflation and income tax – which legally take away money from his pocket and diminish the value of his wealth. Long term statistical analysis has shown that by investing atleast 12% of the total funds in equities we actually reduce the risk (standard deviation) of our portfolio while at the same time improving the returns (mean).

Category III: Investing – Own Money
The third category is of that person who invests his own money in productive assets like equities, rental real estate or in inflation hedges like gold and silver. This is a clever category of investor who converts his income into wealth. He is educated on the principles of finance and investments, knows how to save taxes (dividends from equities are tax free, rentals from real estate subject to lower rate of taxation after deductions, long term capital gains from equities and real estate – after satisfying certain conditions- are tax free), enhances his real income by investing in natural inflation hedges like gold and silver and builds wealth over the longer term. This category of investor does allocate some portion of his wealth towards fixed income but that is more for generating current income and putting some stability to his overall portfolio and not as a means of generating long term wealth. This category knows that an unnecessary revenue expenditure like foreign vacation or gruesome / bad capital expenditure like car, beach house should not come from his “earned” income but from his “portfolio” income i.e. the income from his good assets.

Category IV: Investing – Own & Leveraged Money
This is the ultimate category and the person with the highest financial literacy. He invests not only his own “earned” money in productive assets but also borrows (leverages) and invests the borrowed funds in productive assets. He understands the basic principles of how to use money to create money. He realizes the fact that the cash flow from his productive assets have to be good enough to repay the interest EMI on his loan. He knows how to create a productive asset out of thin air. This is the category who literary prints his own money. For example, he has “earned” income of Rs.25 lacs. Now, he borrows (leverages) Rs.25 lacs from the bank and invests Rs.50 lacs in a “rental real estate” at 8% yield or Rs.4 lac p.a. Assumes his EMI on the housing loan is Rs.25000 per month or Rs.3 lacs p.a. This person literally makes Rs.1 lac p.a. (4 - 3) which is 4% yield on his original money of Rs.25 lacs i.e. savings bank rate. However, after few years the loan gets repaid, the property becomes his own and the rentals keep flowing in making his return on investment as “infinite”. This is called “creating asset out of thin air”.

To conclude, earning money is the first premise of being wealthy but by just earning money nobody can become wealthy unless he understands how the principles of finance work in this modern information and currency age and then makes money work for himself. Remember, you have limited time and energy at your disposal to “work for money” and hence unless you make “money work for yourself” you cannot become wealthy and once money starts working for you, there is no time limit, no boundary to which it is subjected – it can just keep creating and multiplying wealth and you can legally print money for yourself.

All the best!  

No comments:

Post a Comment