Posted in Personal finance

Take off to the aerial view

Today I am flying to India. I am very excited and looking forward to visiting what is my second home now.

As the long flight from US started very early this morning, a few thoughts on personal finance hovered around my mind.

Before the flight takes off, there are a number of events that take place more like items in a checklist. As the plane’s technicians go through their routine yet stricter checks, as a passenger we too go through some disciplined steps like reaching the airport on time, checking in, clearing though security and finally boarding in a queue. All of these steps are important and must be done in sequence.

Then as I put on the seat belt and the plane takes off, the mind switches off from the low level sequence to a higher level composure. The plane rises above the clouds and I can see the world top down.

Personal finance is also the same. As you go through the low level details of controlling your expenditures, paying your credit card on time, automating a few bills on the way, you slowly but steadily reach the state of composure as if your financial life has taken off the grounds.

You no longer worry about petty coupons and discounts, or avoiding the crave for that latte, or even recording each transaction in your budget app.

Instead, now your systems are automated and you have a pretty good idea of how much is spent every month and how much you can invest.

Now your focus shifts to the clouds and you need to only take a top down view of the financial landscape. You start learning more about various investments, real estate, taxes and start strategizing on how to grow all areas of your personal and financial life.

You can now see personal finance is not just about money but when managed well, can allow you to cruise in other areas of your life as an aircraft in a turbulence free sky.

For example, this holiday is completely planned and paid for and I do not need to stress about credit card balance to afford the cost of the trip.

Complete the ground steps in a defined sequence as the suggested posts below, and then focus on the bigger clouds.

Budget – Grow the tree upside-down

One essential comfort zone

Investing in the High Five portfolio

The clouds that you can focus on once done with above are:

  • Taxes and how to find tax efficient investments
  • Insurance
  • Estate planning and wills
  • Passive income generation
  • Career goals
  • Your potential for earning more
  • Having fun

From time to time you do need to come down and go through the low level steps again, as I am in transit now in JFK airport.

I will be flying to my destination in a couple of hours again.

At the end the sequence matters. You can imagine how chaotic it would be to rush through security without checking in your bags first.

The cruise comes later when you are a disciplined traveler and follow the steps.

Posted in Personal finance

How to decide on a purchase – the P.V.T formula

I talked a lot about budgeting, saving and investing money in the earlier posts.

Budget – Grow the tree upside-down

One essential comfort zone

Investing in the High Five portfolio

However a fact of life is no matter how hard you try, there will be big purchases.

Some of them will be needs, while others may be simply wants.

These purchases are typically big ticket ones and can range from a thousand dollars to several hundred thousand dollars. For example, it can be an Apple iPhone/iPad to buying real estate for a primary home.

How do you decide when the purchase makes financial sense? After all, money will be spent and an opportunity to invest will be lost forever.

The P.V.T equation explained below helped me make the decision many times.

Although I have made bad decisions and recovered, but on hindsight sticking to a principle would have helped to be sensible 90% of the time.

What is the P.VT. equation?

The acronym stands for three important elements of a purchase decision.

  1. Price
  2. Value
  3. Time

To assign a score value to a purchase, it will have to be a combination of the relative success with above three parameters.

The main thing to guard against a purchase is whether it is a waste or not. So if we measure the waste factor, and try to keep it as low as possible, it is a sensible purchase.

The formula is as follows:

WF(Purchase) = WF(Price) x WF(Value) x WF(Time)

Where WF is the waste factor, in terms of how much of that parameter we are giving up during the purchase. Since it is a multiplication, a WF of zero will be approximated to 0.01 (1%).

Lets take 3 examples, an iPad, a car and a house.

iPad Pro: 

Price ~ $1000 and lets say it being Apple, we cannot manage a discount.

So WF(Purchase) = 1.0 [we consider the full price as 100% waste factor]

Value – How much value will it add to your daily life? Are you going to use it for work, or just recreation? It will also depend on whether you have other laptops or similar tablets at home. Lets say you are going to use it for personal work (like reading, keeping tab of investments etc.).  So you will use it 40% of your screen time.

Thus WF(Value) = 60% or 0.6

Time – How many years are you going to use it compared to the typical life of an iPad? Given that it is a technology product, the maximum life it can be used without needing replacement or becoming obsolete is probably 5 years. But you may be upgrading anyways after 3 years.

So WF(Time) = 2/5 or 0.4

Finally, WF(iPad) = 1.0 x 0.6 x 0.4 = 0.24

So 24% of the price is wasted. If you could have bought the iPad at 25% discount, then the purchase value will increase.

WF(discounted IPad) = (1.0 – 0.25) x 0.6 x 0.4 = 0.18, so now the purchase makes a little more sense.

Car: 

Typically it is a good practice to buy used cars at a discount. So lets say you buy at 40% discount, usually a 2-3 year old car.

Let us also say that this is your primary car and you don’t fancy owning 2-3 cars, so you will use it 90% of your commute time. And lets say you are going to upgrade after 5 years, even though a car can be kept for 10+ years.

WF(Price) = 0.6, WF(Value) = 0.1 (high value to you), WF(Time)=0.5

WF(Car) = 0.6 * 0.1 * 0.5 = 0.03

See this is much better usage than the iPad with a WF of 0.24. Now if you hold the car for 9 years, then 9/10 will give a better score.

WF(Car) = 0.6 * 0.1 * 0.1 = 0.006

House: 

This is the biggest purchase in most people’s lives and possibly can be better quantified as well.

We will make the following assumptions:

  1. Price – You will buy the house at 20% discount to the retail/asking price.
  2. Value – If this is your primary residence, the value may be very close to 100%, or the WF will be 1% (to avoid zero).
  3. Time – A house can be held for 20-30 years, but lets say you plan to upgrade after 10 years or so. So WF(Time) = 20/30 = 0.66

WF(House) = 0.8 * 0.01 * 0.66 = 0.005

So the house purchase makes even more sense than the car. Even though the house is used only 1/3 of its whole lifetime and the car is used 9/10 years, the house purchase makes more sense. It also had a lesser relative discount than that of the car.

The above P.V.T equation also reveals another hidden aspect. You can adjust one parameter vs. another. For example, if you are going to use the house or car for longer, you can afford to buy at a less discount. Your WF(Price) will increase but will be offset by the other two.

You can even use this formula when you are trying to compare paying a higher price for a high quality product or buying cheap for a not-so-durable product.

High Quality: WF(Price) = 0.8 or higher, WF(Value) = 0.6, WF(Time) = 0.1 (it will last long) , WF (Purchase) = 0.048

Low Quality: WF(Price) = 0.5 (less price), WF(Value) = 0.6, WF(Time) = 0.5 (last 1/2 as long), WF (Purchase) = 0.15

As you see, it makes sense to buy the high quality product if the value is same for both. At least in this case, however there are situations where if you can get a significant discount and know that the item will last longer, the lower quality product (non-branded) may outperform a branded one. 

Thus making purchases with such logic will keep your home clutter-free as below. You just have to choose a suitable threshold of the WF. For example, anything below 0.05 (5%) may be a good thumb rule to make the purchase.

Disclaimer: There will be many other factors in a purchase decision. The above formula acts as only a quick thumb rule and should not be the only criterion for decision making. 

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Posted in Personal finance

Beware of ripoffs

Everyone does financial mistakes, some large some small.

The personal finance industry is designed to chase you for your money, for obvious reasons. The people working in this industry has to make a living and profit. Nothing wrong with it, however there are some unscrupulous greedy professionals and companies who will siphon off your money before you realize what happened.

I too have been a victim of such tactics, where that sinking feeling is unavoidable once you realize you have been swindled. You vacillate between blaming yourself for being careless to simply justifying as how would I know.

I have made other stupid mistakes many times, thankfully most of them were small.

Here are 2 big ones which I will remember throughout my life, and hopefully draw some lessons not to repeat the same.

Insurance masquerading as investment

In 2005, when I started my journey of personal finance (I was earning for 8 years with no savings/investment), I decided to open an investment account with one of the big international banks in India. They had what was called a “Wealth Management” division that would help me all the way in opening an account to choosing my investments. What a convenience! I just had to commit a specific amount to be invested by a certain time, either through a lump sum or regular investment.

So I met with what they call a Relationship Manager. The lady came to my home to advise me, suggested some good mutual funds (I later researched they were decent performing ones) and setup an investment account. I was thrilled and excited to start my first investment, and then came the unsuspecting pitch.

She told me investments in mutual funds are risky, so alongside I should also invest in something very stable with tax-free and better returns than a CD. Diversification, Tax-free and stability all sounded perfect music to my ears, and I resonated to her plan. What followed next was I signed up for a so called U.L.I.P (Unit Linked Insurance Plan or Cash value life insurance).

So far so good, only couple of years later I inquired about the fund value or the surrender charges. By this time, I started reading about charges and commissions on financial products. To my utter disbelief, the product I signed up for (which seemed perfect then) had a special charge of 60% of my first year’s premium. They called it the Premium Allocation Charge. Wow!! Why would you charge to allocate my money? and 60%?

Even robbery at gunpoint would have sounded harmless in comparison. 🙂

That was my first big ripoff, I eventually bailed out of it few years later by minimizing my loss. In the subsequent years, the I.R.D.A (Insurance Regulatory and Development Authority of India) realized this dishonest practice by insurance companies and their agents, and reduced the charges to more like 4-6% and now it is clearly documented in brochures and illustrations.

Lesson: Do not mix investments with insurance. Insurance companies have no edge over low cost mutual funds. If there is a guarantee of principal, the returns are paltry and most of the profits are distributed to their agents. For insurance, term plan has no better substitute.

Fact check: In later years, I came across a relative who was selling such products. He told me agents who perform well are rewarded with paid for vacations to destinations in Europe. No wonder where 60% of my first premium went. 

Real estate bought wrong

Real estate is a high return, high risk product. Even when you are buying a home, you have to be knowledgeable in every step of the process, guard yourself against potential rip-offs. Everyone you come into contact is trying to make big bucks (and very quickly) in that industry.

My share of stupidity in this area is huge.

I bought my second home (condo) in India from a new builder, but who was also very well known to me. His claim to fame was honest communication, promised execution, good discounted price and quality of construction. The deal was really a good one, from both price and quality.

As things progressed (the development cycle was for 3 years), I became confident and  upgraded to a bigger sized condo. As the earlier one was not delivered, it was an arrangement to switch the contract to the new one and I would be paying the difference.

It was like upgrading to business class from the economy class, by paying the fare difference. Except that it was not such a smooth ride. 

The blunder I did was not to insist in a new contract being signed immediately and the title of holding the new condo to be defined. Since the builder was known to me personally, I somehow gave the benefit of trust and waited patiently for him to switch the contract. Meanwhile as the payment system demanded from his office, I continued making the scheduled payments up to almost 90% of all dues.

A year down the line, things went south for this builder and I realized that something is wrong. On digging further, it came out that the new condo was not approved in the building plan and cannot have a regular title yet. Just to clarify, there is no Title insurance or Title company in India. Usually the transactions are directly between buyer and seller (or builder) with an optional broker mediating in between.

It took me the next couple of years to untangle the mess, and I lost a huge amount of money and mental peace in getting the title legitimized.

Lesson: Know the process and only thing you trust is the paperwork. Do not take any verbal assurances. In the above incident, I had only myself to blame for the stupidity. 

Fact check: I later came to know it was a deliberate lie (while selling the unit to me and in my follow-ups) by the person (builder) I knew very closely for years. Trust no one. 

So those are the two biggest financial suicides I signed up for.

crime scene do not cross signage
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Posted in Budgeting, Investing, Personal finance, Savings

The Starter Kit

If you are just starting off with organizing your personal finance, or restarting from scratch, here is a step by step way to get started.

Most of the times, we get started haphazardly, the first account in the local bank or the ad-hoc insurance policy or even the next stock tip forces us to open a  brokerage account.

However there is a need to get started in a more planned way.

When I moved to the US couple of years back, the below is how I setup my money system. I had a similar one running in India for a long time and it has given me very good results.

Here is the starter kit that you need to get organized and get started. 

Since it is built in a systematic manner, it will help you automatically organize and keep your finances in order.

A checking account

This is the first step as you need a place to deposit your income, be it direct deposit from your employer or you get checks at the end of the month.

Get a simple checking account at a Credit Union which provides you with a basic ATM and Debit card. Try to find a credit union or bank which has very low fees. Obviously they will have some like overdraft fees that we will anyway avoid, but others like ATM access are something unavoidable, so shop around a little.

This is where all your income will come in and get deposited. 

A credit card

We are going to be responsible spenders, right? If not, do not get this and use your debit card from your checking account.

The key to being a responsible spender is to make a budget, stick to it and pay off the credit card bill in full every month. Lets just assume you agree to all of this. 

There are many credit cards in the market with various features like cash back, travel rewards etc.

As a starter kit, you will just get one from the same bank or credit union where you hold your checking account. The reason is ease of payments and setting up automatic transfers from your checking account to pay it off at end of month. 

The bonus will be of course if  the card also has generous cash back benefits or other similar perks. But get a free one and not one with annual fee loaded just for extra perks.

The credit card will be your main expense vehicle. It gives you automatic fraud protection, insurance and easier account tracking. 

Budgeting

If you do not do any further, you have setup the very basic system. You earn money which get deposited into the checking account, you spend with your credit card (on a budget!!) and your checking account pays it off every month.

But this sounds like living paycheck to paycheck or Living on the Edge, right?

We are going to do better – save and invest. 

First what we need is a planner. As the above system of checking account and credit card gets working in a flow, you will start getting an idea of how much you are spending every month.

For the next 2-3 months, track your spending to categorize your money into only 4 parts.

  • Food and Dining
  • Utilities and Transportation
  • Clothing and miscellaneous
  • Surplus

You will automatically get motivated to squeeze the first 3 categories and increase your surplus every month. 

Check out this post on how to budget: Budget – Grow the tree upside-down

The above technique will help you generate surplus for both savings and investment, make it your goal to only increase it and not fall back to paycheck to paycheck cycle.

Savings Account

There are unexpected events or expenses that will always come up. You need to be prepared for it and the only way is to build up a cash cushion.

One essential comfort zone

This is similar to Dave Ramsey’s first 3 baby steps, where you start with saving $1000, then get out of debt (hopefully you have none if you started with this) and finally build a cushion of 3-6 months of expenses.

I use an online savings account like CapitalOne 360, Ally Bank or Synchrony. There are many others, and online banks provide little more interest on your deposits than brick-and-mortar banks, or the one where you have your checking account.

Setup an automatic transfer of your Surplus from your checking account to this Savings account. Set this up for beginning of the month, so that your budget works with just the right amount needed (to pay off the credit card at end of month). 

Investment Account

Get to this step only when you have a running budget, able to generate surplus consistently and stacked up 3-6 months of expenses in your savings account.

From here on, you become a pro in personal finance as you are about to invest and grow your net worth. 

There are two main investment accounts, a retirement account and brokerage account.

Contact your employer for a 401k (Pretax or Roth) account and contribute to it, if there is a match. If this exhausts your projected surplus, no worries you have got started.

If there is still surplus, good news. Open a brokerage account in one of Schwab, Vanguard or Fidelity. Preferably open a Roth IRA account if your income is within eligible limits.

Roth IRA rules

Then invest in one or two broad index funds with very low expense ratio (< 0.05).

Here is a classic 3-fund portfolio from Vanguard index funds.

  • Vanguard Total Stock Market Index Fund (VTSAX)
  • Vanguard Total International Stock Index Fund (VTIAX)
  • Vanguard Total Bond Market Fund (VBTLX)

Similar portfolio can be constructed from Schwab Funds too.

https://www.wallstreetphysician.com/three-fund-portfolio-using-schwab-index-funds-etfs

Managing and growing the investments

You have done a great job in the above steps and at par with average disciplined investors.

In investment world, “average” is what wins. If you get average returns of 8-9% over a very long time (decades), there is nothing more you need to do. 

To know how to structure and maintain your investment accounts, read this blog post

Investing in the High Five portfolio

Conclusion

The above is a simple 5-step process to take you from a personal finance newbie to a disciplined investor and saver. Taking action in a systematic way is the key to financial bliss.

If you need motivation to get started, read this:

Shun that perfection

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