Financial prudence

Over the last few months, I have read about and discussed various financial management topics with my friends. I used to think I was lost in terms of knowing where I was heading in managing my finances. Since then, I have actively organized my finances and have set some goals. I am pretty comfortable now about which direction I am going with my finances and would like to share with you about what I have learned. You can comment, correct me or give me your frank opinion as I think gaining knowledge about personal financial management is a long continuous process. This is but a beginning of an exciting journey of self realization, self exploration, gaining knowledge about the finance world, becoming a savvy investor and keeping in mind a vague final destination of financial security. I say vague because if you set a definite target, you might feel like a looser if you don't get there, but getting somewhere there is the whole point and hence the vagueness. Its not like if you don't have a definite amount of wealth by certain age, you are not doing well. Doing well entails many dimensions in life. Financial security and contentment is one of many dimensions using which a person analyses his or her own success. Here, however, I will just focus on the financial dimension.

Everybody's risk profiles are different. Some people can play more aggressively, some people cannot bear to get in debt, some people want more safety than others, hence use your own judgment to make decisions in your own money matters. I personally do not like the idea of improved standard of living on credit. However, I am not going to talk about how much should you invest in what, I will just layout my own strategy going forward. Of course, this is subject to change with more experience about the field and my relative risk taking ability.

When it comes to money how should one think about where to put the money? How much to save? How much to invest and in what? I think the first thing that a person needs to know is where he or she is and where he or she wants to go. This starts with knowing how much does the person spend on an average in a month. This, knowing what you earn and spend, will help you in finding out how much can you save or how much you need to. It is the basic cash flow management. If the outflow is more than the inflow, clearly a change in lifestyle is in order. After knowing your in-flows and outflows make sure you set aside some money for the rainy day, and you will have your share of rainy days sooner or later, no matter how much or how little you earn. As they say, its not how much you earn, its how wisely you spend.

I like to have 3 layers of safety nets with decreasing level of liquidity. Two very important concepts which cut through all of these are Dollar cost averaging and compound interest (or just compounding).

Lets first talk about these two before going any further.

a. Compound interest (or compounding):

Its a simple formula that we have learned and used in our primary school math education yet we do not really understand the implications of this very powerful tool.

The equation is: P = C (1 + r/n)^nt

where

P = future value
C = initial deposit
r = interest rate (expressed as a fraction: eg. 0.06)
n = # of times per year interest is compounded
t = number of years invested

Let us assume you start with a capital of $10000, with 4% interest rate compounded twice a year (e.g. a 6 month CD) would produce a sum of $14859.47. That is a lot more than 4% per year.

http://www.webmath.com/compinterest.html

Here is a better java based graphic calculator which you can play around.

http://www.dinkytown.net/java/CompoundInterest.html

If the interest is compounded everyday or more number of times, the interest you gain increases.

b. Dollar cost averaging:

This is a known way of saving yourself from market volatility. It is a strategy where you invest a fixed amount at a fixed interval in the same asset. For e.g. Stock funds, Index funds or Bond funds. This protects you from the ups and downs of the markets and you can sleep at night without worrying about how you are doing that day. When the price of the stock fund goes down, your fixed amount buys more number of stocks and when the price goes up, your fixed amount will buy less of that fund. Thus, the value of all the stocks together will be averaged out. This is more advantageous if the stock/fund is more volatile. There are couple of websites which talk about this in detail.

http://www.fool.com/foolu/askfoolu/2002/askfoolu020523.htm
http://moneycentral.msn.com/articles/invest/invfund/1304.asp

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Let us now talk about what are those three security nets.


1. Ca$h (Savings accounts)

You need this for first line of defence against any mishap in your life. This also works as a buffer if you overshoot in spending more than you earn in a month. This happens every now and then as there are some payments which are six monthly like your car insurance or automatic saving plans or that speeding ticket, anniversary, birthday etc. Every Tom Dick and Chaudhary has an account in ING direct. It gives you the best interest rate as it doesn't have actual brick buildings like other banks and hence has lower expenses. Of course, this cannot replace the banks/ATM network which is necessary. So, splitting your savings account between the two kinds of banks, internet based higher interest paying vs. brick and mortar and lower interest paying, is prudent.

2. CDs or FDs (Certificate of deposits or Fixed deposits)

It is necessary to put some of your savings in CDs. There is no point in making all your savings earn a paltry interest in a savings account when you know you won't need this money. This is something which doesn't give you money instantly like the savings account and thus, protects you against your impulsive behaviour to blow away your savings account. This is something which you should be able to tap into if in the hour of the need, your savings run out. In my philosophy, you should have enough money to survive 1 year without any income while maintaining your current standard of living. 6 months worth of supply in saving and remaining in 6 month CDs. Of course you can do your own combo throwing in a CD ladder. I say, 1 year but this period is flexible and should be decided by the individual depending on the kind of industry that a person works in, the market conditions which can dictate how soon can you find another job and their own needs.

3. Investments (Stocks, funds, real estate etc)

After having put your house in order, then you should start thinking about making your rest of the money earn a little more than paltry interest that banks give you. If you see historically, the markets have given 8-9% returns annually over a long period of time. In my opinion investing in stocks is a gamble, you never know what is going to happen and when all the institutional investors will dump the stocks making your returns suffer. So, in my opinion first you should do indexing with automatic saving plan and sleep with peace of mind that you will earn at least 8% annually without sweating the news every minute with one finger on the sell button. I am not saying you shouldn't invest in stocks, just that even if you can analyze the company by its financial statements (balance sheet, cash flow statement, income statements and its annual report) you do not have the time to look for the latest news every minute. Even if you did this daily, you might earn good amount few years and then make terrible losses in other years bringing your rate of return the same as indexing if not worse. It is a well known fact that 85% of the active fund managers are beat by the market every year. So, if you just do indexing with automatic saving plan, you can be assured of beating 85% of the oh-so-smart fund managers.

Real estate is a separate game altogether. In my opinion, first I would like to have a roof over my head somewhere if all hell broke loose. After that, you can begin to buy your primary residence where you are working by taking out a huge loan. Keep in mind that debt to income ratio of 4-5 is as high as you should go. Anything higher than that is a huge risk. In my opinion, the bubble or inflated asset value shouldn't be a concern as far as you can take care of the loan in the worst possible increased interest rate scenario. After all, you are not going to earn the same salary all your life. But, go in for a long haul vs. a quick 3-5 year stint as any asset, even with real estate, the prices do not go up faster than other fundamentals like economy and incomes. If they do, be assured that they will come back to the real gains. According to finance professor at Univ. of Pennsylvania, Jeremy Siegel, average asset value of houses have gone up less than 1%, yes you read it correctly, less than 1% over a 100 year period. Two key things to keep in mind, it average and 100 year period.

Retirement Saving

Do not miss out of the opportunity to save for your retirement right from the beginning. The sooner you start, more money you save. It doesn't matter if you start small, but it is very important that you start early. Do not let go of any of your company's matching contribution to your 401K plan. In fact try to be as close to maximum as possible. Do not rely on social security as social security is going to be in trouble very soon. We do not know whether we will get that amount of money by the time we retire. So, actively manage your 401K investments. There are automatic funds like Fidelity freedom funds which invest very aggressively, meaning more in stocks and less in bonds, when you are young and as you get closer to your retirement age they reduce the investments in stocks and put more in safer bonds. I, at least now, like to take more control over how and where I invest my money.

I also believe that when you get older, you probably won't live in an area like downtown San Francisco and would like to live somewhere quieter. I believe in older age, you would probably need less money as you wouldn't take a season pass for snowboarding in Aspen. But this is me, make your own judgment and save for retirement but at the same time do live a little now.