An MDI alumnus and CFA charter holder with 11+ years of experience in designing investment strategies for asset managers, ETFs, and hedge funds, Karan leads the investment research, investment operations, and investment advisory functions of Elever with the responsibility of delivering customized investment strategies and investment portfolios tailored for unique investment goals of retail investors. Armed with a strong grip on numbers and trust in the power of compounding, Karan is also responsible for developing algorithms to add a deep layer to the goal-based financial planning and personal finance framework that handholds investors through the investment journey over their lifetime.
If you discuss personal finance in your professional and personal circle, you would discover that almost every individual appreciates the importance of a healthy savings rate and a wealth surplus. Yet, in most cases, young individuals believe that their savings are too low to make a big difference in their future wealth and they are better off spending that money on an expenditure that can provide instant gratification and Joie de Vivre. Additionally, many individuals spend their 20s and 30s under the assumption that there is an entire lifetime to plan for big-ticket items like home and retirement.
Every healthy habit is enforced through discipline. Personal finance management is integral to your financial health and mental peace. Following some ground rules with discipline and devotion can ensure that you are ahead of the curve in wealth building.
Saving-First Approach
Savings-first approach is built on the 20/50/30 thumb rule which enforces some minimal savings for individuals and households. This approach entails the following
- Once you receive monthly income, as a first step, transfer 20% of your monthly income as savings into a different account. These savings must not be touched for any expenditure.
- Cap essentials expenditures such as food, fuel, conveyance, loan EMIs, rent, essential house help, essential clothing, etc. to 50% of monthly income.
- Cap non-essential expenditures including vacations, travel, adventures, luxury goods, outdoor dining, entertainment, etc. to 30% of monthly income.
If essential expenditures are more than 50% of monthly income, an individual must cut non-essential expenses to accommodate essentials. It ensures that allocation to non-essential expenditure act as a buffer against overshoot in essential expenditure and there is no adverse impact on monthly savings.
If one feels that 80% (50% + 30%) of present income is insufficient to sustain the desired lifestyle, one can back-calculate how much monthly salary is needed to accommodate lifestyle needs. That provides an individual with real targets in terms of professional and income growth. Savings-first approach ensures that if needed, instead of savings, lifestyle expenditure would be put on the backburner.
A higher savings rate can have a multiplier impact on wealth. By the mid-30s and 40s, individuals must strive to achieve a healthy savings rate of 35%-40%. Ideally, the savings rate must increase with age which can be achieved through the following: –
- All bonuses and additional income must go into savings.
- 50% of future monthly income increments must be allocated to monthly savings.
We have Saved, Now What?
With inflation averaging at 6% and savings held in a savings account with post-tax returns of 3%, savings end up bleeding 3% (6%-3%) of purchasing power every year. Investments of savings in long-term investment vehicles not only ensure retention of purchasing power but also speed up the process of wealth creation with higher return potential.
However, apart from investing, savings must also be contributed to creating an emergency fund equivalent to 3 months of monthly income. Placed in an easy-to-access savings account, an emergency fund is supposed to take care of temporary financial emergencies without impacting long-term wealth. Going by this definition, FDs, PPF, EPF, EPS, NPS, and Mutual Fund Investments cannot qualify as emergency funds.
Considering inflation and emergency fund, savings can be managed in line with the following principles: –
- If there is already sufficient emergency fund corpus, savings equivalent to 5% of annual income must be contributed to the emergency fund corpus.
- If there is insufficient emergency fund corpus, 33% of annual savings must be contributed to the emergency fund corpus.
- Remaining annual savings must go into investments. The investment process must be ideally approached in the following manner: –
- First INR 2 Lakhs of annual investments must go into 80C tax-savings instruments. Ideally INR 1.5 Lakh of investments must go to EPF/PPF and the remaining INR 50k must go into the NPS scheme.
- Remaining amount must be invested in long-term investment vehicles such as FDs, Equities, Bonds, Gold, Mutual Funds, NPS, and other long-term investment schemes.
Though equity mutual funds have a stellar track record of much higher annual investment returns (12%-15%) than FDs and Bonds (6%-8%), equity returns are not guaranteed. Equity MFs can incur huge losses (40%-60%) in the short-to-medium term. Unless the investment horizon is equal to or more than 10 years, individuals and households are recommended to invest savings only in safe instruments such as FDs and bonds.
Time-Compounding is the King
In their 20s, most working professionals believe that their savings are too low to make any impact on future wealth. However, wealth-building is more about time-compounding than contribution. Let’s consider the example of Mr. X who aspires to have a wealth corpus of INR 1 Crore by age of 40.
1 crore Target at Age of 40 and Impact of Delay
| Age of Mr. X at time of First Contribution | |||
| 25 Years | 30 Years | 35 Years | |
| Monthly Contribution Required | ₹ 20,000 | ₹ 43,000 | ₹ 1,20,000 |
| Investment Duration (in Months) | 180 | 120 | 60 |
| Total Investments (I) | ₹ 36 Lakh | ₹ 52 Lakh | ₹ 72 Lakh |
| Investment Gains (G) | ₹ 64 Lakh | ₹ 48 Lakh | ₹ 28 Lakh |
| Total Corpus at age of 40 Years (I +G) | ₹ 1 Crore | ₹ 1 Crore | ₹ 1 Crore |
| % Gains | 177% | 92% | 39% |
As readers can deduct from the table, had Mr. X delayed investment initiation from 25 years to 30 and further to 35 years, the investment gains would have declined gradually from INR 64 Lakhs (177%) to INR 48 Lakhs (93%) and further to INR 28 Lakhs (39%), respectively. Despite the significantly lower monthly contribution at INR 20k starting at age of 25 years, higher investment gains unlocked by an early plunge at age of 25 years and time-compounding ensured that INR 1 crore target is achieved by age of 40 years for Mr. X. Delays on part of Mr. X to 30 years (gains of 93% vis-à-vis 177%) or 35 years of age (gains of 39% vis-à-vis 177%) on account of starting with a bigger contribution has failed in compensating for a severe shortfall in time-compounding gains.
Moreover, starting early with small contributions can be a booster shot for personal finance in later years. Let’s say, at age of 35, Mr. X is expected to start a family and has a monthly income of INR 2 Lakh. As a family man, Mr. X might have some additional priorities such as retirement planning or a dream home. 20k monthly contribution accounts for only 10% of monthly income, leaving a big chunk of savings to be allocated to these new responsibilities. However, had Mr. X started late at age of 30 (contribution of INR 43k) and 35 (contribution of INR 1.2 Lakh), monthly contributions would have accounted for 21% and 60% of monthly income, respectively, leaving lower savings for new commitments at age of 35 years. The absence of time-compounding gains would force Mr. X to make either compromise on his commitments or take tough calls on cutting expenses.
With each delay, you are paying an opportunity cost in terms of loss of time-compounding gains. Starting early with even a paltry investment contribution significantly improves the odds of building optimal wealth while maintaining a reasonable savings rate and without sacrificing on present lifestyle.