Personal Finance Essentials
Getting started on managing expenses and saving for the future
College graduation is an important event in many of our lives, for those of us who were privileged enough to afford college education, that is. It signals many changes that are often permanent in nature. We are no longer students. Completing assignments at the eleventh hour gets replaced with completing Powerpoint presentations just before the meeting. Classmates and professors are replaced by colleagues and managers. Etiquette, that defines what is appropriate and what is not changes. We can’t deny our adulthood anymore. And suddenly, what Monica said to Rachel makes complete sense.
“Welcome to the real world. It sucks. You’re gonna love it” — Monica Geller, Friends
Along with the innumerable responsibilities that come our way, comes financial freedom as well. Financial freedom can be heady, at first. Suddenly, we have money of our own, to spend on things that we want to! People start valuing our time, in a more explicit way. Paying for tuition - spending time to “learn” gets replaced with spending time at the office and getting paid for that time. And we go on a spending spree!
We think that we’ve just started earning and there’s a lot of time before we need to worry about financial planning. And before we know, we would be many years into our jobs with no real savings to our names.
I started earning almost four years ago. Though I have always tried to get a grip on my expenses, it has never been easy. We live in a consumerist society after all and it is not very easy to stop ourselves from buying useless products and services. (Well, the MBA grads who get into sales and marketing need to do something to justify their salaries, after all, right? Also, right now, we are all living amidst a recession, which is partly due to people cutting down their non-essential spends. So, if you, my reader, are a spendthrift, please know that you are playing a very important role in keeping the wheels of our economy spinning. You are the hero, the economy doesn't deserve, but the one it needs right now.)
Over the years I have made numerous attempts to get better control over my personal finance, some of them have been glorious failures while others have been promising. In this article, I am passing on to you whatever little I have learnt on personal finance. It is a continuous process and it would take a lot of discipline and fine-tuning to get to your very own personal finance framework, that fits perfectly for your lifestyle. Acknowledging this would probably be the best place to begin the journey.
Setting the table
Any personal finance framework needs to address two important aspects:
- Managing current expenses
- Saving for future expenses
In managing current expenses, we’ll talk about the need for knowing your expenses, optimizing your spending behaviour and managing your debts.
In saving for future expenses, we’ll talk about the need for an emergency fund, what is inflation and why it is a silent killer, making a well-balanced portfolio and portfolio monitoring.
For any framework to function as intended, it is important that there are periodic monitoring and feedback mechanisms in place. We shall conclude this article with some thoughts on that.
Please be aware that this article is not in any way exhaustive, but I am hoping that it gives the reader a framework to start building personal finance habits around.
Managing Current Expenses
Knowing your expenses:
This is not rocket science, but hardly any of us do this deliberately. Knowing your expenses should be the first step of your personal finance framework. This exercise will help us understand those expenses that we hardly seem to take note of — like our Netflix and numerous other video streaming subscriptions, which we hardly ever use.
- Choose a weekend, make a hot cup of tea, sit down, open a spreadsheet application, download all your expenses — your savings account statements, credit card statements, digital wallet statements, etc.
- Choose the latest month and put down every transaction that you have made during that month onto the spreadsheet. Tag against each, its “Spend Category” — food, commute, rent, entertainment, travel, utility, shopping, loan etc.
- Make sure to exclude any expenses that are one-off in nature, like the money you’ve lent to your friend or the examination fee you’ve paid for an exam you are planning to take solely because everyone else in your peer group seems to be taking that exam.
Optimizing your expenses
This is where you try and make changes to your spend pattern.
- Find out what % of your monthly expenditure can be tagged as “essential” — this category of expenses are usually not optimizable and includes rent, utility bills, grocery expenses etc.
- The other “non-essential” expenses are where there is scope for optimization
- Optimization can be done in two ways: 1. Eliminate spends that are not justifiable (like unsubscribing from the music/ video streaming services that we seldom use); 2. Find alternatives that do the job but costs significantly less (like switching from eating out every day to hiring a cook)
- More often, the impact of looking at what part of your income is spent on unnecessary shopping or eating out can be a motivating factor to initiate behavioural changes. Full disclosure: It is much easier said than done. It is still a work in progress in my case.
Managing debt
Debt management is often overlooked when we talk about personal finance- primarily because they seem rigid and give very little scope for optimization. But, what we fail to understand is the significance of a few basis points reduction in our loan interest rates.
To illustrate this, let us assume a home loan of INR 50 lakhs with a 20 year tenure at 9% annual interest rate.
The total amount payable (principal+interest) comes out to be INR 1,07,96,711
Now, let’s see what is the debt when the interest rate is reduced to 8.5%, a mere 50 basis points less.
The total amount payable reduces to INR 1,04,13,879, which is a good 3.8 lakhs cheaper.
So, it turns out that the return on effort (the benefits we reap for the efforts we put in) of keeping a tab on the loan rates in the market once (say) every 6 months is pretty good!
Let’s briefly touch upon credit card management before we wrap up debt management. Credit Card is the costliest of all loan products out there. Banks charge around 30% p.a in comparison to 12 to 15 % charged for personal loans. Hence, the single most important thumb rule for managing your credit card expenses is to pay the dues in full. Banks provide the option to pay only the minimum amount (which is often only 5% of the total due) in order to not incur penalties. But, it must be noted that the remaining balance incurs the high interest charges, which is the major source of revenue for credit card issuers.
Saving for Future Expenses
Setting up an Emergency Fund
As Monika Halan says in her Personal Finance book Let’s Talk Money, the first step before one can start their investment journey is to set up an Emergency Fund that can be dipped into during times of crises. She goes on to say that as a rule of thumb setting aside 3 to 6 months of your cost of living would provide a good safety net.
Why stashing away money is not the best way to save
Traditional thoughts on saving money are usually around cutting down expenses and depositing money in a savings account in a bank. But, what we fail to account for is that 100 bucks today is worth less than that in the future (in an economy that has a positive inflation rate). Inflation rate is nothing but the rate at which the purchasing power of a currency drops. Hence, it is important that the interest rate that we receive on our savings is more than the inflation rate prevalent in the country.
India’s retail inflation rate for the month of Jun’20 was computed to be 6.09%. Savings accounts in banks offer interest rates in the range of 3% to 4%. By depositing your hard-earned money in a savings account, you get 4 bucks after a year for every 100 bucks you deposit today, but at the same time, something that costs a 100 bucks today will cost 106.09 bucks in a year. Which means, your money will not grow in real terms but in fact, reduce.
Hence, looking at inflation-adjusted interest rates is important.
If you are interested to know more about the need to beat inflation, I would recommend you to check out Raghuram Rajan’s famous Dosanomics explanation.
Building a portfolio that works for you
There are numerous ways to save money — starting from the traditional savings accounts and fixed deposits to bonds, equities, etc, each with its own risk-return characteristic. It is important to understand that risk and return go hand in hand. If an investment is providing you higher returns, it is likely to be riskier as well.
Hence, it is important to have a portfolio that is appropriate for an individual’s risk-taking abilities. Savings accounts are safe but provide low returns. And on the other extreme, equities are risky but provide high returns.
A general rule of thumb is that a well-balanced portfolio should have an Equity composition equal to (110 – age) %
For beginners, mutual funds (which are equity/ bond portfolios that are managed by “skilled” individuals called Fund Managers) are the best place to begin their equity investment journey. Value Research is a great source of information on investing in mutual funds.
So, what happens to the rest of the portfolio, you may ask. The other (100-Equity)% of your savings needs to be invested in Debt instruments like savings accounts, Fixed Deposits, etc.
With the advent of mobile banking and the facility to open and close Fixed Deposit accounts instantaneously, I would argue that it is beneficial to open 10 FDs of 5000 INR each and have 10,000 INR in savings account than have 60,000 INR in the savings account. With more and more purchases getting done through credit cards and digital wallets, the need to have liquid money has reduced.
Implementing your Personal Finance Framework
Now that we have discussed the components of a personal finance framework, let’s spend some time on how to implement the framework. After all a framework that is not well executed is bound to fail.
Monitoring and periodic adjustments
Variables change, operating conditions change and hence for any framework to continue functioning it is paramount that it is monitored regularly and tweaked when needed. Our lifestyles, expenditure, income and interest rates change over time. As a result of which our framework might stop functioning as intended. So, there is a need to monitor how well the framework is doing.
Identify the frequency of monitoring for all components of your framework:
- Identifying and optimizing spends can be done less frequently — say once every 6 months
- Maintaining your Equity:Debt split needs more frequent adjustments as any incremental cash flow and expenditure alters this ratio — say monthly. This activity also enables you to keep a tab on your monthly spends
- Monitoring your loan interest rates — say once every 6 months
Leverage mobile applications:
There are numerous freely available mobile applications that you can leverage to help run your framework smoothly. Some examples are given below:
- Google Calendar to set-up recurring reminders for monitoring
- Google Sheets to monitor your portfolio composition
- Moneycontrol to track your Equity portfolio and stock market trends in general
- Your bank’s mobile banking application to open/ close FDs in real-time
We’ve come to the end of the article, folks. I hope this helps you get started on the much needed personal finance management journey.
If you are interested in exploring this topic further, check out the books and podcasts mentioned below.
Have a good life! :)
Books on Personal Finance
- Let’s Talk Money by Monica Halan
- One Up on Wall Street by Peter Lynch
Podcasts on Personal Finance
- Paisa Vaisa by Anupam Gupta
- Zerodha Educate by Zerodha
