Understanding Finance in this second part of the Wealth Series to push you more toward your Financial Freedom
In my earlier article, I shared the definition of financial freedom and its different stages. You want to read the first part of this article to gain perspective on building wealth.
We will answer the questions about ways to build wealth and what I have learned from my mistakes by exploring the following
- Reasons behind not being able to save money
- Strategies to save more money from a primary source of income.
- Investment instruments to compound your money
As I explained in my earlier article, one of the significant hurdles to building wealth is to be able to save money regularly. If you can save money, you can invest them periodically too.
Saving money is a discipline that one has to abide by. Rags or rich does not matter. If your salary is high, your lifestyle may correspond to that income and expenses. Before 2018, such as 2014, my income(8 years back) was decently in 5 figures in USD, but I struggled to manage savings and investments.
Because my expenses were controlled mainly by my wants rather than needs, I would buy stuff driven more by my desire than my need and utility. For example, I purchased a Trek bike which cost around $800 back in 2015, and I have ridden it only 100 miles to date. A general bike would have cost only $250 then.
So my desire cost me around $550 extra, an expense with no utility.
Here are the reasons for your low savings
- You are not able to differentiate between your needs and wants.
The solution is relatively simple. Before buying any stuff, ask yourself these two questions.
First: What is the utility of this expense? Why this, and why not cheaper alternatives?
Second: If I do not buy it, will my work or growth suffer? Why am I buying this now?
2. You are influenced by others’ opinions more than yours.’
This situation is very typical in any salary class people. You get influenced by your friends’ choices, peers in the office, and random people in the meetings. You see stuff they are using, and you get attracted to its appeal. You cannot explain its utility but still want to have it. This is where you do not want to get stuck. It lures you into buying such stuff out of fascination and a fanciful lifestyle.
What is the solution, then?
You start by believing in yourself first. Try to gauge its utility on paper by listing the pros and cons. You extrapolate your finances one year forward and measure the expense’s impact on your current financial situation. If the cost impacts your saving requirements, you should not go for it.
3. You prioritize your current comfort more than your future’s comfort.
When you think about spending your salary in the first few days of salary credit, you are more driven by your current lifestyle. You are not contemplating the future lifestyle that may get affected by your irrational spending. This is a vicious habit loop that recurs every time you have money.
You get money, and you want to fulfill your long pending Wishlist. Thus your savings never see the light of the day.
Such a habit can be avoided by thinking about your wealth goal. You want to think about your future savings. A 10-year wealth goal may provide better clarity on your current commitments. Thus contemplating future savings, you can avoid spending on today’s unnecessary comforts.
Moreover, the savings eventually lose their value to external factors such as inflation, emergency expenses, and opportunity costs. However, if appropriately invested, you can appreciate savings to a considerable size. This is where wealth creation takes place.
4. Your affordability is not what you can buy with ease money.
All three reasons mentioned can be considered situations in which affordability will not have a significant impact. You spend because you have money to spend, and it does not interfere with your daily needs. However, there is one situation in which no one wants to get into.
If your income does not suitably meet the expense you are doing, you take Easy Monthly Installments (EMIs) of lower value and extend them over a long time. This is suicide. You do not understand that you are accumulating huge liabilities by doing so.
You start with paying EMIs on one product, and then you end up paying such EMIs for three or four or more products over an extended time. This eats your savings because you have a liability to pay every month, and thus your savings are affected. Over two or three years, you probably will have more needs or tools that you want to buy, and this cycle of EMIs rarely ends.
Avoid getting into this cycle by periodically observing your EMIs as a percentage(%) of total expenses. In my view, EMIs should never cross 10% of your monthly expenses.
So now we know the reasons for not being able to save money, let us dig into how we can save more money. If you see it from one perspective, learning to avoid spending, as mentioned above, can be reasoned as the way to save more money.
If you follow the above process, naturally, you will save more. However, I want to add a few more things that you can do to save money. To get the best out of it, performing these steps sequentially and simultaneously will allow an individual to build wealth effectively and impactful.
The first thing you can do to save more money is pay off high-interest debts. High-interest debts generally include credit card debts, Personal loan debts, and Payday loans. Credit card charges are usually between 36%-42% annually for loans. Similarly, personal loans’ interest rate ranges between 12%-24% annually, depending on the loan issuer. Payday loans are costly loans. The interest rate is 0.5% to 1% per day. These loans are short-term loans for people who do not have money to sustain themselves until the next paycheck.
However, if your salary gets delayed, you will pay very high interest for the money you borrowed. Paying off these loans will enable you to save more money in principal and interest.
My second strategy is to hoard contingencies and emergency funds for future uncertainties. The reason is straightforward. Even when you save your money to create wealth, you need to extract the costs from your wealth portfolio if emergency funds are not available. This is undesirable as both money and time have been spent doing the saving.
When such a thing happens, you lose motivation to save more again for the wealth generation. Thus your emergency fund comes into the picture during such a crisis. If you deploy some portion of savings into an emergency fund, you can utilize the fund when needed.
Doing this will not affect your wealth portfolio, and thus you remain intact on the path to financial freedom.
Generally, an emergency fund should have six months to 12 months of living expenses.
You can perform the above first step and this second step simultaneously to overcome the financial instability. Remember, emergency funds are capital required at the time of crisis. So, you cannot expect a drawdown of its value.
Hence, investing emergency funds in stocks or other volatile markets is not viable when you are just starting. You can make a recurring deposit in Banks, which gives you at least a 4% interest and is a financially guaranteed investment.
If you manage to do the first two things mentioned above, your monthly savings will probably increase substantially as your debts and funds are taken care of. So the third thing you want to do is make a few changes in your expenses to save more. This third step can also be done simultaneously if possible. You can consider this when your costs are below 60%. Your debt is low and around 10–20 % of your expenses. Your emergency fund is in progress and is only 15% of your income. Then you can make enough changes in your expenses order.
Start by categorizing your expenses into accommodation, food, travel, and medical. Doing this will enable you to observe monthly payments and make amends to those visually.
Suppose your monthly expenses are $600, and your food covers almost 40% of your costs. In that case, your food expenses will be $240. When you convert your categorized expenses into a percentage, it gives you how much your expenses are necessary and wasteful.
A $240 expense out of $600 expenses is too much. This indicates either your food habits are luxurious and unthoughtful, or you mostly eat packaged foods or restaurant foods.
You can reduce such expenses by partly cooking at home and dining outside. This is just an example of how you can arrange your expense order if you can make some changes to your lifestyle habits.
One of the most effective ways in my financial journey has been to track my expenses and priorities. Priorities will help you to manipulate the savings equation from the expenses side. It would be best if you did this
Expenses= Income- Savings
Rather than doing this
Savings = Income- Expenses
Both equations are the same but slightly manipulated for priority. In the first equation, Savings is your priority, and thus whatever is left after savings are your expenses. This will happen only when you have a budget for savings every month. So keep track of your savings budget.
In the second equation, your priority is your expenses. So after meeting all your expenses, whatever is left is your savings. This indicates that your priority is your current wants and needs but not future savings.
There may be a few minor changes in your spending behavior that you can adopt to avoid the second equation. Always wait for a few days or weeks before you decide to buy something. This habit will allow you to contemplate the spending requirement and its utility.
Always track your recurring expenses. Monitor those expenses as % of your monthly payments. Then categorize them into needs and wants. You will come to a point where you can differentiate and cut down on those “wants.”
Now that we covered ways to save more money, let’s put our savings into wealth creation. Wealth creation is not a gimmick or short-term strategy. One has to learn the process to gain wealth. If applied religiously, financial freedom is not that difficult to achieve. Here are the two ways that you can use to generate wealth from your monthly savings:
- The traditional way:
Since your high-interest debts and emergency funds are taken care of, building wealth in this conventional way is all about consistency and diversification. Your primary source of income should be a high-paying job. Having a high-paying job will allow you to invest a minimum of 30% of your income in different financial instruments. Remember, the more your salary is, the less percentage of your income is required to invest.
As a rule of thumb, a saving of 30% of your income is needed to invest in Stocks, Bonds, digital assets, etc.
2. The alternate way:
Not everyone has a high-paying job. If you fall in that category, you need to add another source of income to your primary income. In this era of the Internet, plenty of side hustles can generate more money. Some side hustles require skills. These can be writing, coaching, consulting, social media marketing, copywriting, coding, or creative design.
Some do not require skills such as working part-time in a restaurant, car wash, delivery executive, courier handlings, etc. Your skills will guide you to the side hustles. But if you have skills, then there are many platforms through which you can earn while sitting at your laptop.
Here is a list of side hustle ideas that you can refer to.
The Stable instrument: Bonds, Savings accounts, Provident funds, etc are the most stable form of investment. During the recession, bond markets generally provide good returns over stock markets as the Central bank’s interest rates are high during a recession. Allocations are subjective, but I try to put a 10% allocation during recession time in the bond market. Similarly, savings accounts and provident funds(PF) are guaranteed instruments that provide an inflation-adjusted return.
In my country, the savings rate is around 4%, and the PF rate is hovering at about 7.75–8.15%, which is attractive.
So an allocation of 30% of my savings is invested in the PF account voluntarily.
The Volatile Instruments: In this category, I put common Stocks, High dividend stocks, index funds, and other Mutual funds. These markets are volatile, but you can obtain an annual return of 7–12% with knowledge. High dividend stocks are good products to invest in as capital appreciation occurs in stock valuation and dividend payouts.
Index funds are probably the easy way to expose yourself to equity markets. Having a sizeable allocation in index funds is suitable if your skills do not allow you to invest in stocks.
If you have good market skills, allocation in individual stocks is a better alternative as the market conditions are not always constant. Any good correction in the market can serve you an entry.
30–50% of your savings are suitable for these instruments as a rule of thumb.
The super volatile instrument: This category is the least allocated instrument due to its high volatility. Crypto in the form of Smart contract Blockchains, DeFi, Web3, NFT, and Metaverse tokens are some of the instruments where you allocate a portion of your savings. Since it is highly volatile, the returns are also high if invested in good projects.
The allocation should not cross 20% of your savings.
Investment requires discipline and knowledge of the market apart from capital. Current market conditions can be a good entry for your portfolio allocation if invested well. As the recession and inflation fears are all around the globe, a market correction is what you need to get a reasonable margin of safety
Keep an eye on the market, and the market will reward you well.