Posted in Investing, Personal finance

Active vs Passive Investing

There is a continuous debate that goes on in the context of investing through mutual funds.

Should I choose funds which are actively managed or choose Index funds which simply mirrors an index?

Some experts are strongly opinionated in favor of Index funds, whereas investment firms will always tout active investing for obvious reasons.

So what should we as investors choose?

Let’s see the different reasons why Index Funds are better choice for most investors.

  • Index Funds simply cost much lesser yet gives you the returns of the market.
  • Index Funds provide instant diversification from flavors such as Total market Index to specific themes and international market indices.
  • Index Funds do not have the need to reward performance and compete with other funds.
  • Index Funds do not need to trade very often, thus saving unnecessary tax liability due to capital gains.
  • Index Funds are simple to understand and follow.

So in an efficient market like the US, where information about good companies is widely available, beating the benchmark indices is not easy for fund managers. There are star fund managers who may have done that, but the percentage is very less, typically < 5%.

The simplest and most convenient in the US is the proverbial Bogleheads’ Three fund portfolio. 

https://financinglife.org/best-books-on-investing/bogleheads-guide-three-fund-portfolio

However the story may be different in other parts of the world, for example, emerging markets like India.

There are evidences of active fund management overtaking Index returns and in the short to medium term, even with the high costs of management, beat the index fund often.

However this is slowly changing and in recent years, the Index Fund is tilting to be the better choice for long term investors.

With more institutional money flowing into Index Funds as well, Fund managers will find it difficult to beat the index returns and the market efficiency will move towards that of developed markets like the US. To quote an article, it clearly shows the trend.

Over the last couple of years, many investors have increased exposure to index funds as returns from several categories of actively-managed funds failed to beat the Nifty 50 returns. In the past one year, the Nifty 50 has returned 12.51%.

 

Thus no matter where you are investing, Index Funds are the simplest and the most efficient choice for a portfolio.

Index fund investing is like sticking to the basics, just invest for a very long term and you need not worry about the noise of the investment world.

composition of different conchs on beige table
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Posted in Investing, Liabilities and Debt, Personal finance, Savings

The Five ways to SIP

SIPIn India, the mutual fund industry has popularized this term for drip investing, dollar cost averaging or similar. The full form is “Systematic Investment Plan” and allows normal people to invest in Mutual Funds gradually and is proven to build wealth over a long time. 

For me, there is a bigger SIP in Personal Finance – Sleep in Peace. 

It may sound like RIP – but lets keep life going strong in these trying times. We will do another article on that, and in personal finance terms we will call it Retire in Peace.

SIP is a concept that is important throughout your earning and retired life, and defines a way you can manage your Personal Finance to effectively “Sleep in Peace” every night.

As we know with the current COVID-19 situation, many people are losing sleep over their financial situation.

While some can still be corrected with discipline, those following the basic principles of SIP will be unaffected by such pandemics and sail through it.

The Five components of a SIP method

1. Emergency Fund – The sleep in peace fund

The Emergency Fund is the first of SIP rules. It can be called the Sleep In Peace Fund too.

In the current situation where everything is uncertain from jobs to ability of paying mortgages and bills to medical situations, there cannot be a better cushion than possessing an emergency fund.

People who have not been able to build this fund, are now feeling the brunt of their careless handling of personal finances.

One essential comfort zone

2. No Debt – borrower is slave to the lender (there is no good debt)

In US, due to low interest rates on some loans like mortgage and auto-loans, some experts justify using leverage to build your wealth. While that may sound smart in good times, in trying times like now even a so called good debt can nosedive to a bad debt.

For example, the government is now directing banks to suspend mortgage payments (for a short period, of course), giving stimulus to real estate investors and trying to bail out or let leveraged people and businesses go down.

So greed and over-smartness with debt are now taking the sleep away from people who have bought and financed huge houses, expensive cars, invested into rental properties with no-money-down. Here are 3 situations where not having an emergency fund and being over leveraged, is disastrous now.

  • You spend more than 30% of your income in mortgage payment. If you lose your income, even the emergency fund will quickly run out paying the mortgage.
  • You bought an expensive car with bank financing and very low down payment. The auto-loans will not get any relief from Government, and your car may be repossessed in case you fail to make the payments. Also the payments could have been used in more protective ways, if the car was bought with cash in the first place.
  • You invested in rental properties with low down payment (< 20%). What happens now when many tenants are refusing to pay rent due to financial hardship or even just taking advantage of the situation (evictions are deferred now). You still need to pay the bank their share of interest and principal.

The universal truth about Dave Ramsey’s 7 baby steps

3. Do the real SIP – invest in a disciplined way

Now we come to investments and the real SIP (Systematic Investment Plan).

This process addresses two damaging financial behaviors – fear and greed.

I will not rant about the philosophy behind SIP or DRIP investing, it is pretty well known and over-emphasized in investment circles.

The advice from the legendary investor Warren Buffet applies now more than ever.

Be fearful when others are greedy, and be greedy when others are fearful. 

However in the Sleep In Peace method – be neither, irrespective of what others are doing. 

Keep investing with a plan. I have rearranged my India portfolio recently (just before the market crash) and apparently could have done better.

  • In a zeal to restructure my asset allocation, I invested a large part held in cash into the equity markets in Jan 2020. Little did I know, the markets would come crashing down in another month or two.
  • However I was not overzealous on Equity. I kept a larger part in simple fixed deposit (bank CD), so as not to go overweight in one asset class, Equity. 
  • The current market situation does not affect my peace, since the money I invested into equity markets is planned to be held for a long time (possibly till I retire). 
  • I could have done better if I remained patient and deployed it in smaller chunks over several months  – the real SIP. 

So that’s from a recent personal experience –

If you want to Sleep In Peace, invest with SIP – the systematic investment plan. 

Know yourself and your investments

4. Define and invest in your goals

No matter what is happening in the world, nothing can derail you in personal finance if you manage your finances based on your goals.

Every person has life goals like buying a house, opening a business, travelling the world, educating your children and RIP (Retire in Peace).

If you allocate your money to the various goals and keep adding to the corpus month after month in your earning years, then in trying times such as now – you have nothing to fear. Some of your goals are funded and some are in the process of getting built-up.

Just continue doing what you were doing.

The worst case scenario can be that one or two goals may need to be postponed. For example, if you were trying to retire early and lost your job or income, you may have to work longer for a few years more. But that does not completely cripple you or force you to liquidate your retirement funds.

A simple method of asset allocation

5. Pay your taxes and file your return on time

Taxes and death are certain – everything else is uncertain. 

There is no way to avoid taxes (except the legal ways to reduce or defer it – consult a CPA) and hence every personal finance system has to take into account – taxes. Not paying your due taxes and trying to be over smart, can really take your sleep away.

Whatever it takes, plan for your taxes throughout the year and pay the legitimate share to Sleep In Peace. 

In the US, Internal Revenue Service and in India, the Income Tax Department are both quite aggressive in following up with cover-ups, non-payment and mistakes. And for working professionals like me, who has to deal with both – there is no other way than honesty, prompt action and discipline in keeping track of your tax liabilities and payment obligations.

Keep your documentation up-to-date and file away returns on time to avoid major headaches.

Five components of a personal finance system

Conclusion – Ride the wave and learn something new

While this is the time for great financial worries and the clouds of a multi-year recession looming over us, there could not have been a better time for us to introspect and re-organize.

This is the time to take a hard look at your financial and other priorities in life. Locked down inside our homes, with more family time and me-only time – when is a better time to introspect and find your real dreams? 

When the world was open and running, the rush of the morning and the fatigue of the evening left little for us to think beyond the next day.

If you want to sleep in peace when all this is over, maximize this opportunity and start something new.

I am working on starting a financial coaching business where I can help people with their finances globally. What better time to serve the world than now and next few years? 

Who moved my cheese? How to deal with changes in financial plans

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Posted in Budgeting, Investing, Liabilities and Debt, Personal finance, Savings, Spending

How to manage your cash flow

A company which is listed in the stock market has to publish 3 essential financial statements.

  • The balance sheet
  • The profit and loss statement
  • The cash flow statement

Briefly, the balance sheet shows the health of the company at the reported time, profit and loss statement shows how much profit the company is making after all expenses and taxes, and the cash flow shows how the company is generating the cash from its operations as well as investments.

Free Cash Flow (FCF) is an important metric that is used by investors to evaluate the real worth of a company. 

In personal finance, while balance sheet (Your net worth) and profit and loss (how much you are making and spending) are important, managing the cash flow is key to achieve your financial goals.

In this blog, we will talk about how to manage your cash flow – no matter whether you earn a lot or earn an average paycheck.

Most people do not manage their cash flow, forget about doing a budget or any other conscious form of tracking.

At the end of the month or year, we wonder where all the money earned went.

Conventional ways of managing cash flow

There are several techniques Personal Finance experts have championed time and again.

  1. Do a budget, track every dollar. 
  2. Create an envelop for groceries, utilities, fun etc.
  3. Use separate accounts. 
  4. New automated solutions like Stash, Digit etc. 

All of these are good methods, but the problem is sticking to the discipline of maintaining it day after day, month after month.

Isn’t that boring and worrying at the same time? Few issues with these approaches are:

  • Writing down expenses every day
  • Stuffing that envelop and counting the money every time before spending
  • Keeping track of multiple accounts
  • Not knowing how much the AI driven savings app is going to deduct next month

So is there a simpler and better way?

Just like most posts in this blog, I seek simplicity and automation.

The simpler way of managing your cash flow

There are 4 goals to managing the cash flow every month.

  • Invest for the future
  • Save for the short term
  • Pay your bills 
  • Spend the rest

In fact, any wind-fall is also a one time cash flow, and can be fit into the same framework.  Lets say you got a bonus of $1000, for example, the Govt is sending a check to all Americans. And if you want to keep it simple, allocate 25% to all the 4 goals.

  • Invest $250 in your long term (retirement, child education) plans. The market is down and you can invest $250 in a mutual fund or an ETF. 
  • Save $250 for any short term goals that you have. It could be added to your monthly savings goals, towards anything like vacation, buying that new phone, or simply emergency fund. 
  • If you have consumer debt, why not allocate some to pay it off? Use $250 to pay off the highest interest or smallest balance credit card. 
  • Now you have $250 to splurge on. Buy that favorite book, order the special meal or decorate your home. 

But how do we automate and manage the cash flow every month?

  • Invest – Direct deposit investments. In fact most employers have systems to auto-deposit 401-k investments or direct deposit to your chosen brokerage firm. 
  • Save – Auto transfer to a savings account from your checking account. 
  • Pay Bills – Setup auto-pay with your credit card or debit card. Set the bill payments mostly towards beginning of the month. 
  • Spend – Use your debit card to spend – it will tell you when the money runs out. 

Once setup, the only stress you have is the last bullet, where you have to make your spending within the limits, or rather the residue after all obligations are set aside or paid off.

How it can snowball into Financial Freedom

As you get consistent with stashing money away for investing and savings, those may generate additional cash flow or assets which will come back to bolster the spending budget.

Thus cash flow is a virtuous cycle once set up the correct way. Lets take some initials and approach this from a math perspective.

  • J – Job Income
  • R – Retirement
  • I – Investment
  • S – Savings
  • B – Bills
  • E – Expense
  • P – Portfolio Income

J + P = R + I + S + B + E

I can produce P in terms of interest, dividend or rental income.

silver and gold coins

In the wealth accumulation years, the goal should be to increase J, so that I can be increased, which when invested can increase P. P is added to J and a part reinvested, saved or used.

As you reinvest P, it will generate more P till at a point, J becomes less and less important. 

This cash flow situation is called Financial Freedom.

Conclusion

We just presented a simple and fully automated cash flow management system for personal finances. It does not take much discipline and will power to stick to it, once correctly setup.

This is also explained in more detail in the post The SAFE plan – Simple, Automated, Flexible and Efficient .

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Posted in Investing, Personal finance, Savings

A simple method of asset allocation

As I started to write this post, I decided not to rant about the Corona Virus and its effects anymore. The last two posts were dedicated to the topic and frankly it is becoming a little bit weary to add to all the deluge of information and opinions on it.

Let’s look at the current situation as nothing unexpected, at least financially. Being a financial blog, let us generalize this to another black swan event, and not worry about the statistics of no. of confirmed cases vs. deaths etc.

What is a Black Swan event?

A quick Google search yields the following:

An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. This term was popularized by Nassim Nicholas Taleb’s book “The Black Swan: The Impact of the Highly Improbable.”

Lets leave it to that and consider we are in the midst of one such situation.

The keyword in the above definition is “would be extremely difficult to predict”. 

No matter what financial experts say about the markets, about investments, using sophisticated algorithms to trade stocks, the fact remains that such events are not predictable by even the multi-PhDs of Finance.

In the beginning of 2020, most of us did not know that a black swan event is so much closer, although experts have been predicting recessionary clouds for last 2 years or more.

The effect of such an event is the havoc it can do to your savings and investments. Yes savings too, as we don’t know which banks or financial institutions will go under the water, and whether government stimulus can rescue them.

It may be a rare event so far, or some rescued in 2008 but we cannot guarantee with every black swan event. Just in Feb 2020 (when it was still normal business), a very large private bank in India went bust taking with it hundreds of thousands of dollars worth of deposits of very normal people. Ironically the bank was named “Yes” bank.

Similarly by end of March 2020, the stock and mutual fund portfolios are down 20%-50% depending on how much risky the portfolio was to begin with.

The only respite from all of this is to maintain a good asset allocation as each investment avenue has its own risks. Some of the typical risks are:

  1. Cash – Banks going down and Government struggling to insure the deposits.
  2. Stocks – Markets tumbling for an extended period of time due to economic fears.
  3. Bonds – Risk of default as even good companies’ bonds can turn into junk debt very quickly. Lot of mutual funds in India were invested into Yes Bank bonds. Long term bonds can also run into interest rate risk.
  4. Real Estate – Somewhat resilient but affected by vacancy, interest rates, unemployment.

If your finances are severely affected by this storm, how do you achieve a good asset allocation once the clouds are gone and the sun is shining again on the stock market?

KISS – Keep it simple, stupid

Its not overly complicated although some financial experts make it so. Let’s say I want to hold 25% each of the 4 asset classes and distribute my assets accordingly.

Here is a step by step method on how to achieve this. It is better done in an Excel sheet as the calculations can be automated and even graphs can be plotted, although equal allocation is easy to visualize anyway.

  • List down all your assets into one column which comprises your Net worth including your home and any other property you own.
  • Now in a second column, list the value corresponding to the asset. Be conservative, do not add any speculative value.
    • For your home, just take the equity value that you have.
    • For stocks or mutual funds, take the present value.
    • For any bond investment, take the invested value or the expected maturity value (if the term is not too long).
  • Now add 4 columns for the asset classes.
  • The chart should start to look like this. Here is a simple example of a $100,000 Net worth.

Asset Allocation Table 1

  • Now based on the asset class for each, fill the right side columns in the right proportions. For example the mutual funds  may consist of equity funds, bond funds and REIT funds in equal proportions. For each mutual fund, a look at the fund report will reveal the proportions of these asset classes that it invests in.
  • Fundrise is just an example of a private REIT that is considered real estate asset class but in paper form. It is only for illustration and I am not an affiliate of the investment fund.
  • Once you allocate the numbers to the 4 asset classes and add up each column, it will become visible how your asset allocation is skewed.Asset Allocation Table 2

 

  • A visual inspection of the numbers reveals that this portfolio is heavily skewed towards Real Estate due to the largest investment in the Home. This is true for most people, as their largest investment is their home.
  • A more vivid depiction of this can be drawn using the Excel chart.

Asset Allocation Table 3

  • How to balance it? There is no ideal asset allocation as it depends entirely on the person’s situation, age, risk appetite, goals and many other factors. It is only after this simple analysis that one should approach a financial coach or investment adviser.
  • For example, if the person (who’s portfolio we have just analyzed) is not happy with the Real Estate skew, he can allocate future investments more towards Equity or Bonds (or even Cash), than buying more real estate or paying down his mortgage aggressively.
  • Being overweight in Home Equity can mean house poor and the person will find it difficult to raise funds or access cash in times of emergency or other life goals.

Conclusion

The beauty of this asset allocation method is that in a simple exercise which takes less than 10 mins and one sheet of Excel, you can look at your entire financial picture.

  1. It gives you a quick overview of your Net worth.
  2. It gives you the current asset allocation you have.
  3. It tells you where your financial situation is vulnerable to market, liquidity or economic risks.
  4. It tells you what action you need to take (whether to sell some or boost up another) regarding the various asset classes.
  5. It directs how your future investments should be structured.

The value of this exercise is immense and a good asset allocation can let you sleep in peace when the entire world is savaged by another Black Swan event.

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Posted in Investing, Personal finance, Savings

Locked down – 5 hurdles to overcome

In the last few weeks the world has changed quite a lot. With no sight to an end to the corona-virus spread, cities after cities are going into lock down and people are forced to stay at home.

This will impact the economy in a very bad way and many businesses like entertainment, travel and food will be severely affected or shut down. In these unprecedented times, the current situation of the stock market and its decline is understandable.

Since this blog is concerned with personal finances, let us look at the impact this black swan event can have and how to get over this crisis.

We will examine 5 adverse scenarios and how my previous posts (in good times)  suggested recession proof way of managing personal finance.

Social distancing

This has been enforced in many cities and people are not allowed to be meet each other face to face.

    • This will impact people and their livelihood when it depends on teams and network. For example, direct real estate investing like house flipping, buying houses, wholesale deals and likes.
    • Financial, insurance advisors and their clients who depended on face to face interactive sessions. While this can still be done over video conferencing and online communication, the personal coaching sessions may be less personal after all now.
    • Investments which depended on a broker or branch are impacted since  offices are shut down or low on staff.

The key to solving these issues is to setup systems that enables you to transact virtually from anywhere in the world, including your home. If you have automated your financial systems using FinTech, those systems are not affected by the current situation.

FinTech – can you be immune to it?

Losing jobs or income

    • As various industries are expected to be hit hard by this event, many people may lose their jobs or get a reduced income for an unknown period in the future.
    • This will cause difficulty in managing household cash flows, paying bills, mortgage and tiding over emergency situations.
    • Emergency medical conditions, for example, someone in the household may contract the virus and need to be hospitalized. Even with insurance, it may cause a hefty out of pocket expenditure.

The key to solving such emergency situations is to have enough cash cushion in terms of Emergency Fund and to cover Short Term Obligations.

One essential comfort zone

Investments are tumbling and losing their value

    • Your stomach will have a strange feeling when you look at your stock, ETF or mutual fund portfolios under 401k and Taxable accounts.
    • Almost all portfolios are beaten down 25-30% and may go further down to 50% or more.
    • With the risk of financial institutions and other companies going out of business, even fixed income portfolio is not safe. There may be large scale defaults in the bond market, as companies struggle to meet their short term debt obligations.

The key to solving such challenges is to remain invested and not panic sell out of it at this time.

Afraid of investing? Not so simple either

Fear is gripping us

    • While there had been virus spread earlier, the scale of the COVID-19 is unprecedented and growing.
    • This type of lock down has never happened before, and after what happened in Italy and China, we are gripped in a fear of the fatality rate caused by the virus.
    • This has stopped us from behaving rationally and with our investments, people may be reacting with the same fear. I have read many discussions on Quora where people are predicting a long recession and advising others to pull out investments or completely stop investing more.
    • Fear is the worst enemy and negativity is biggest killer of future prospects.

The key is to remain calm and take necessary precautions (staying at home, frequently washing your hands etc.). Similarly for finances, do not take up unnecessary debt at this point but just remain invested and keep your monthly investments ongoing.

The biggest enemy of your investments

Not building new assets

    • While there may be a recession ahead, this may be the starting of a good time to buy assets.
    • Our net worth is beaten down due to the stock market crash, and this is not the time to rue over the loss.

Instead we should focus on increasing the underlying asset values and look to the future for those assets to throw in cash flow and appreciate.

The Net worth vs. Cash flow debate

Conclusion

At the end, we all have to realize that the world will tide over this crisis.

For our finances, we just have to carry on doing what matters and take a long term view.

If you adopt the SAFE plan as in below post, nothing should really change.

The SAFE plan – Simple, Automated, Flexible and Efficient

With the forced shutdown, learn a new skill indoors and do not worry about your investments.

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Posted in Investing, Personal finance, Savings

The 4-Q way of protecting your finances from coronavirus driven volatility

One of the questions all investors consider is how to spread their investments. This is super essential in a volatile economic environment that we are now being forced by coronavirus.

Coronavirus is already sending stock markets across the world in a downward spiral, companies may find it difficult to service debt and hence affect bonds, and interest rates going downwards put cash and money market funds into useless investments.

How do we then allocate our funds and make sure we are not into an all-or-none, boom-or-bust kind of situation?

There are essentially 4 kinds of investments that a simple investor like us will hold over time.

  1. Cash and cash equivalents – CDs, money market, timed deposits etc.
  2. Debt – Fixed duration and fixed income products like bonds bought and held till maturity.
  3. Market Linked – Index Funds, Mutual Funds, ETF, direct stocks, REITs.
  4. Real Estate – Properties (homes and rentals), Private REITs.

The 4 Quadrant approach

The below table shows how these investments fit each quadrant of a time horizon vs. liquidity.

Financial PlanningLiquidNot Liquid
Short TermQ1 – Cash and Cash EquivalentsQ2 – Debt (Bonds till maturity, other lending investments)
Long TermQ3 – Market linked (funds and stocks)Q4 – Real Estate

For example, cash and debt instruments are typically short term reserves. While cash in savings account is highly liquid, bonds typically have a fixed maturity duration unless they can be traded in the secondary market.

On the contrary, stocks and funds may be liquid but typically yield best results only over the long term, due to short term market volatility. Real Estate is both long term and highly illiquid since it may take months and years before a property investment can yield profit or get sold.

If we allocate our resources with the 4-Quadrant principles in mind, then the short term market volatility or conditions will not bother us much. Each of the Quadrants will have enough invested/saved to go through the current phase.

For example, if I need immediate cash or want to maintain an emergency fund, Q1 is the place. There is no need to panic sell Q2, Q3 or Q4 investments.

Similarly for a medium term (2-4 years), the required funds can be maintained in fixed duration bond products (Q2) matching the maturity to a goal horizon.

At last, stocks and real estate are for the long term (> 10 years) and should be left to grow on their own. We can keep adding to them in a well defined proportion. But we do not need to panic sell them if the Q1 and Q2 are in place.

Simplest Asset Allocation

Another advantage of this approach is automatic asset allocation. Sometimes without realizing we may be overweight in one Quadrant. For example, some people may be just lazy to invest and keep their money lying in savings accounts, hence Q1 heavy.

While others may be so overweight in Stocks and Real Estate that in case of an emergency or reaction to market movements, they may sell or trade unnecessarily and hastily. Worst is premature withdrawal from retirement funds and paying penalty and taxes.

A balanced allocation to each Quadrant based on goals is the right approach.

For example, lets say I have $200,000 net worth. I can allocate the following after estimating my monthly expenses ($3000) and near term goals (Education, buying a house etc.).

Q1 – 6 * $3000 = $18,000 in money market fundQ2 – $40,000 for a new house in 2 years – Treasury Bond Fund
Q3 – $42,000 in 401-k and Roth IRAQ4 – $100,000 in present home equity

Lets analyze few scenarios here. 

  1. I suddenly lose my job – Assuming it will take 4-6 months to get a new job, I can withdraw from Q1 my monthly expenses and tide over this crisis. 
  2. I need to save for a new house in 2 years – I keep saving every month in Q2 and buy investments maturing in about 2 years.
  3. Whether the above events happen or not, the Q3 keeps growing as the funds remain invested in the market. In fact, as long as there is no crisis, I can keep making dollar cost averaged investments every single month into 401-k and Roth IRA accounts. 
  4. Q4 is even longer term and can be one’s own personal residence and additional rental properties. If Q1 and Q2 are in place, there should not be any hurry or knee-jerk reaction to sell or lose these valuable assets.  

The actual amounts or assets can vary depending on a person’s goals and needs. 

Overall this framework will also avoid a person to go into debt unnecessarily. Similarly paying off debt or mortgage can be considered money invested in Q2 and Q4 respectively. 

Conclusion

The 4-Q is thus a simple financial planning framework. Sticking to this 4-Q framework and directing one’s monthly investments to the relevant quarter helps build wealth in the long run, as well as take care of short term obligations. 

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Posted in Budgeting, Investing, Personal finance, Savings

Who moved my cheese? How to deal with changes in financial plans

The title is taken from a famous book as below. Even though it is meant to be a management philosophy, it applies to the subject of personal finance as well. 

Financial Planning does not work? 

There is a proverb in the military – Plans are good till the first bullet is fired.

Some of us who are obsessed about managing or advising on personal finance can go really overboard with planning. Have you heard about those retirement numbers, college planning or even financial freedom number?

While long term planning is good, problem with personal finance is that it is a not a standalone aspect of your life. It impacts and gets impacted by life events – birth/death/marriage/divorce in the family, choice of career or college, changing goals and circumstances and finally your own priorities may change.

How my circumstances kept throwing my plan astray

Lets take an example in my case, as I transitioned from India to US.

Till 2005, I did not know a zilch about managing finances. In fact I was pretty bad at it, just enjoying my life and like many, used to blow up my entire paycheck in frivolous expenses, needless shopping and eating out. So in a nutshell there was no plan.

Then in 2005, I decided I can at least start investing some money out of my paycheck. Good plan but was it anything long term? No it was too flaky as I jumped from one hot fund (mutual fund) to another. This was the time when the Mutual Fund and Private Insurance industry was taking off in India in a big way. I also lost money investing in an insurance plan (actually a bad plan) that was masquerading as investment.

Beware of ripoffs

Eventually as I got better with finances, I actually created a long term plan complete with everything – retirement fund, children’s education fund, vacation fund and corresponding projections several years into the future. I built separate portfolios for each, and tracked them to utmost precision even calculating year after year growth.

However God had other plans for the family. In a series of unfavorable health and personal issues, we decided to move out of India at least for a few years and relocated to US.

This obviously altered my earlier plans completely, since my place of work and source of income changed. The retirement numbers started to look different, the college education fund seemed minuscule when compared to US college costs and all the plans are to be redone again.

Well what do I plan for now? I don’t even know whether I am going to move back to India again in few years or not.

In a global economy mobility is a part of life and no one stays in the same place or country throughout their working life. Moreover as you move, international taxation is another beast which can alter your long term investments (like tax sheltered) into immediately taxable entities. 

Plan to adapt, not adapt to a rigid plan

So finally you have to take into account an ever changing plan, moving from Plan A to Plan B and keep adjusting according to your circumstances.

When I read about estimating expenses at retirement, I wonder how can someone calculate that? Following factors and more can make it completely non-deterministic.

  1. Where will I retire? Different cities and countries have vastly different living and medical costs.
  2. Will it be only me and my wife? What if the children stay with us?
  3. What do I want to do in retirement? Will I work or travel more?
  4. What health condition will I be in?
  5. What other obligations (including social and family) will I have then?

So projecting your expenses at retirement based on today’s lifestyle is like predicting the weather 20 years from now, based on 20 years of past data.

Same goes for College funding. Even if you are saving in 529 or other accounts, do you have a goal or a number in mind? How do you arrive at a number for college costs, when the costs are going up every year? Isn’t that also as variable as retirement? The following factors come to my mind immediately.

  1. Do you know what career will your 5 year old choose when he/she turns 16-18?
  2. Do you know which college will she go to? Ivy Leagues, State or Community colleges? Are the costs not vastly different?
  3. Are you even going to stay in the same state or country when the time comes for college?

In today’s volatile world, planning too far away (more than 3-5 years) is futile.

Planning based on solid principles, not circumstances

The best way to plan your finances is to look at your current goals, aspirations and develop good money habits.

Below steps will help you be in control and act nimbly to adapt to changing situations.

  1. Live below your means – no matter which country or which circumstance you are in, you can always strive for this and become better. Living below your means is common sense, yet so uncommon. 
  2. Budget – Goal based budgeting – This is very important as it ensures you have control over the cash inflows and outflows. Again something which does not change with your place of work or future plans.
  3. Invest with simplicityFind investments that are easy to understand. Index funds, mutual funds, Real estate, CDs and savings accounts.
  4. Keep some portion of portfolio liquid – Sometimes this can be called an Emergency Fund or Contingency Fund. No matter what you call it, it is useful. When I moved from India, I kept a portion of my India portfolio into Fixed Deposits (similar to CDs here in US) and then built up an emergency fund in US too. This gives me option in both places if I decide to just leave work for some time or get laid off. 
  5. Remain consumer debt free – This is also related to freedom. Except for one mortgage in US, I am completely debt-free otherwise or rather bad-debt-free. Being debt free coupled with a portion of portfolio in cash, gives you plentiful of options to enjoy life at your own terms. 
  6. Keep investing for long term – Unless your investments are in countries with troublesome political climate, long term investments (a part of the portfolio) can be left to grow with time. Long term investments work on the principle – its not market timing, but time in the market that will reward your investments. 

To plan and execute above steps in the most efficient way, read the following posts.

Five components of a personal finance system

The SAFE plan – Simple, Automated, Flexible and Efficient

Finally do plan but let life change it

Money decisions should not dictate all your life’s decisions. Money is only a tool to live a good life.

Let your financial plan adapt to your own goals and aspirations, rather than rigidly follow personal finance gurus and templates. 

If someone screams in YouTube to pay off mortgage, it does not mean you have to follow as your plans may be completely different. Similarly you may not fall for all those high reward promising credit cards if you are not going to use those benefits.

A chess player does not know what the board will look like after the next few moves. 

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Posted in Budgeting, Investing, Personal finance, Savings, Spending

The SAFE plan – Simple, Automated, Flexible and Efficient

Safety in financial world is an oft-repeated word, and is mentioned in contrast to risk and growth.

We talk a lot about risk-return trade-off, safety of invested principal in long term and short term investments.

There is another way of looking at Financial Safety. The SAFE plan described below is a way of setting up financial life that is SAFE by design, not in the traditional sense of Safety vs. Risk but automatic habits that ensure you don’t stray from common sense.

Common Sense and Simplicity in Financial Plan is hard to achieve. True it is counter intuitive, but most people land into financial trouble due to complicated behavior – be it spending recklessly, chasing high unrealistic returns or simply throwing caution to the wind.

The SAFE Plan

Let me first present the 7 steps to SAFE plan.

  1. Invest in pre-tax accounts like 401k and HSA.
  2. Set up a direct deposit of the remaining taxable income to a checking account.
  3. Set up credit card payment to be auto paid from the checking account on the 30th of every month.
  4. Set up an auto-invest plan where 10-20% of the taxable income is diverted to a brokerage account or another IRA account (like Roth IRA). 
  5. Spend your monthly expenses on the credit card. Keep an eye on the credit card balance with the money left over in the checking account.
  6. Save the left over surplus, if any. 
  7. Continue and repeat next month … 

Simplicity

The above steps are nothing new. They have been suggested by numerous financial coaches and gurus. However the importance of the SAFE plan is how the steps are stitched together and flows through a seamless automation.

Since we have established the Simplicity of the SAFE plan, lets look at the Automation part and how to set this up. 

Automation

  1. You just need to figure out the % you want to put in 401k or HSA, and inform your payroll department. This can be decided based on the following factors.
    • Your cash flow needs after this deduction.
    • How much to invest to capture any employer provided matching contribution.
    • Max limits of the 401k or HSA.
  2. Direct deposit of the taxable amount to checking account.
    • This is handled by your payroll department automatically.
  3. Setup credit card auto-pay from your bank account for the 30th of every month.
    • This one if not done, can prove to be dangerous as missed payments are very costly.
    • The trigger will also help you pay-off something even if you have amassed a debt.
    • You can configure to pay off the entire balance, minimum payment or a fixed amount.
  4. Setup auto invest for 10-20% of the taxable income. The exact % can vary as it will depend on your household expenses.
    • Even if your budget does not allow this today, find at least a small amount ($50-$100) to divert automatically to an investment account.
    • This will build the habit and set you up for regular investment.
    • The amount can be increased over time as the budget frees up extra cash.
  5. Live within your means. This is again a cliche, but very difficult to be consistent month after month. You can manage it with some automation and discipline though.
    • setup a notification when your credit card balance crosses 90% of your projected expense for the month (or simply the money left in the checking account).
    • Put a Level 5 tornado/hurricane warning when it is crossing over the money left over in your checking account.
    • Typically the projected expenses can be simply set to the money left over in your checking account. You cannot spend more than that without incurring consumer debt or dipping into other savings/investments.
  6. Save the surplus – If you have surplus at the end of the month (that is, Credit card balance < Money in checking account) you can save it for future goals, short term and mid term.
    • I wish banks provided this facility, but it can be set up to transfer a fixed amount once you have an idea of your monthly expenses.
    • Some apps like Acorns or Digit automate this although in more complicated way. 
    • Do not leave the money in the checking account otherwise next month it will create an illusion that you can spend more.
  7. Let the automation run month after month. 

Flexibility

Once setup correctly, the basic version of the SAFE plan is low maintenance and enables an almost debt free living. 

Of course, we have not taken into account mortgage payments, prior debt pay down, saving for education – but these can also be fit into the plan. In the step where you are investing 10-20%, you will break that into smaller chunks of various debt pay down and remaining amount can be invested for various goals.

Thus the plan is also extremely flexible to adapt to individual situations. 

Efficiency

The last part of the SAFE plan is that it is efficient in managing money. 

The following good principles are built-in into the plan. 

  • Pay Yourself First – Pre and Post Tax investments are deducted in the beginning.
  • Low maintenance – no coupon cutting, daily budgeting etc. 
  • Keeps you debt free – just keep tab that your credit card balance is below money left over in checking account. 
  • Encourages more savings at the end of the month – creates a healthy race to increase it, by reducing your spending. 

The efficiency is evident if you do this for even one year. You will see the difference in your credit score, savings balance, net worth and above all, peace of mind. 

Conclusion

This plan has been working for me for a long time. The simplicity and automation helped me manage it seamlessly without getting distracted from my main job – which is not finance. 

And the in-built savings and investment discipline in the plan has helped me invest and accumulate cash for emergencies, short term purchases or just a cash cushion. 

Here is my version of the 7 steps of the SAFE plan (the % are approximate and rounded)

  1. Invest some in the Roth-401k and H.S.A. 
  2. Direct deposit first paycheck. (50% of monthly)
  3. Use the credit card from same account. Set up auto-pay on 30th of every month. 
  4. Investments/Pay downs
    • 10% to mortgage account
    • 10% to savings for property taxes, insurance and maintenance
    • 20% invest in mutual funds via brokerage account
    • 10% to a 529 Plan 
  5. Next paycheck direct deposit on 15th of month. (50% balance monthly paycheck)
    • Living expenses capped to 40-45% of monthly total. 
    • Pay off credit card balance within this limit – I make sure it is $0 as it enters following month. 
    • Sometimes it is hard to stick to the limit, then I have the cash cushion (from previous months’ savings, step 6) to dip into. 
  6. 5-10% savings for vacation/travel, fun, cash – diverted to a high-yield online savings account. 
  7. Keep track every Saturday morning using Y.N.A.B. 

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Posted in Investing, Personal finance, Savings

Afraid of investing? Not so simple either

There are two aspects of investing that are often in war with each other. Fear and Simplicity.

This post is going to look at these two traits of investors.

While Fear is a natural human reaction to market gyrations and an impediment to investments, lack of simplicity on the other hand is another destructive feature of investor behavior.

Fear

For any investor starting on the journey of personal finance and investment, fear is the first thing that comes to play. Following are very common symptoms and questions.

  • What if the stock market goes into a downward spiral?
  • What if the real estate that I buy goes down in value or the rental property is trashed?
  • Even with perceptibly safe investments like bank CDs and money market, the bank can run into liquidity issues or simply go out of business. 

It is this kind of fear, especially the one regarding stock market that keep investors waiting on the sidelines for months and years. And then when the stock market is up, they become euphoric and participate in the bubble, only to confirm their worst fears when the market tanks.

Simplicity

On the other hand, as an investor matures and gets the thrill of investing in the stock market, real estate, he becomes bolder and starts investing in all sorts of esoteric investments like lending products, life insurance cash value and derivatives, futures, options.

While it is good to constantly look for opportunities to make your investments work, one of the fundamental rules of good investment is : “Invest only in what you understand.”

This has become a cliche since the time Warren Buffet revealed that he has followed this principle throughout his investment career. However very few investors have the discipline to keep their portfolios that simple to understand.

Sometimes it is also done in the pretext of diversification. But there are enough easy to understand investment avenues that give instant diversification.

In this post, I wish to provide some solutions on how to deal with these two conflicting behaviors, which are destructive to wealth building.

Solutions

  1. Confront the fear – know thyself and create a plan
  2. Disciplined investing – Time is more important than timing
  3. Correct Diversification – Choose products with built-in diversification
  4. Asset allocation ratios – How to diversify across asset classes
  5. Unconventional investments – Tear down the cover
  6. Load than buy new – Grow vertically, not horizontally

Confront the fear – Create a plan

The best way to address the fear of the stock market and other investing factors is to have a plan.

A plan consists of a hierarchical set of investments that cushion the risk. The plan has to be highly customized to the individual but here are some generic guidelines.

  1. Have an emergency fund – Keep a stash of money in low risk bank accounts (with FDIC guarantee) that can act as ready money available in a bad economy and job loss, unexpected expenses etc. Typically the stock market takes about 12-18 months to recover when it tanks, so some people can be ultra-conservative (specially if one is planning to retire early) and keep cash to tide over expenses for these 12-18 months.
  2. From your monthly budget for investments, allocate a small portion (10%) to play-it-safe, for example to grow the emergency fund or some kind of fixed income investment.
  3. Invest in well diversified index funds first before any other investment. These are low cost and perform well over a long period of time. The S&P 500 index is known to return about 9-10% over multiple decades of time period.
  4. Assign a time value to each investment account and invest accordingly. For example, 401-k accounts are for long term, brokerage account can be for medium term and CDs for very short term. That way, there will not be any pressure to withdraw or sell when the market or economy tanks.
  5. Go slow and do it right with real estate investment. This is the biggest investment we make in our lives and for most people, it is emotional and hence not done with right investment mindset.

Disciplined investing – Time in the market is more important than timing

There are times when we read about a particular investment or hear about it on the news channel, and want to jump in right away. For example, this year 2019, REITs performed exceptionally well and the Internet is full of articles on how to invest in REITs.

But next year it may not be the same. Does it mean I do not invest in REITs? I do invest but in a defined proportion and in the account that is shielded from distribution tax.

Similarly chasing the highest performing stock or mutual fund will result in only speculation, not investment.

  • Keep your investment in a monthly mode once chosen, by setting up automatic investment plan.
  • If you are well diversified, you do not need to worry about which asset class is over-performing. That is the purpose of diversification, isn’t it?
  • Time in the market is more important than timing the market. This simply says keep investing in the same asset month after month without worrying about Mr. Market.

Correct Diversification – Choose products with built-in diversification

Mutual funds, ETFs, REIT Index funds are all products with built-in diversification.

Yet there are portfolios that I have seen which are over diversified. For example, holding more than 4-5 mutual funds with overlapping portfolios does not make sense.

Here are few models of simple diversification:

  1. Total US Stock Market Index Fund
  2. Total International Stock Market Index Fund
  3. Total US/World Bond Index Fund
  4. Global REIT Index Fund

I personally have the following combination – 6 funds at present but I am always looking to consolidate with less. May be the last two can be combined with a Total World Stock Index Fund.

  1. S&P 500 Index Fund
  2. Small Cap Index Fund
  3. Global REIT Index Fund
  4. US Bond Index Fund
  5. International Index Fund
  6. Emerging Markets Index Fund

Asset allocation ratios – How to diversify across asset classes

While the above Mutual Funds or ETFs give instant diversification, they are still victims of the volatility of the trading market.

The stock market instruments can move higher or lower depending on the overall sentiments in the economy. However due to automatic investing and reducing the risk in  a hierarchical manner, it should be okay to digest this volatility.

Although the mutual funds provide in-built diversification in stocks, bonds – there can be other investment outside the stock market that will diversify at the asset category level.

The following asset classes can be added to a portfolio to spread the risk evenly.

  1. Cash and cash equivalents like CDs, money market.
  2. Stock mutual funds and ETFs.
  3. Real Estate Investment Trusts or REIT Index Funds.
  4. Private REIT like Fundrise.
  5. Real Estate buy-and-hold as rental properties, own homes.
  6. Commodities like gold, silver.

Unconventional investments – Tear down the cover to reveal the costs

There are ambiguous investments where the returns are packaged in a way to show it as an attractive investment. Some of these are wrapped around insurance products, while others are mere speculative in nature.

Sometimes these are also packaged as guaranteed return products like annuities, fixed income insurance products etc. While there is nothing wrong in guaranteed return products, these need to be analyzed to see what return they are actually producing.

The concept of IRR (Internal Rate of Return) and NPV (Net Present Value) provide powerful tools to calculate the real return that can be compared to more traditional instruments like treasury bonds, stocks and mutual funds.

Recently I was offered a product in India where I have to pay X amount per year as premium for 12 years, and then I will get a guaranteed return of 2X per year for next 12 years. It sounds interesting as it guarantees a cash flow in future and produces a absolute double return of the original investment.

But when you put it through the IRR formula for 12 + 12 years, you will see the return is close to 5%. 5% guaranteed return can still be good, if I am okay to leave the money invested for so long. These products typically have very little liquidity. Hence I would have been stuck in the contract for next 12-24 years for a return of 5%. Why not invest simply in stock mutual funds, which should produce more than 5% and with much better liquidity if kept out of IRA accounts?

Similarly I have been offered Guaranteed NAV plans (NAV – net asset value), where it is market linked but the company is guaranteeing a limited upside. The problem is not that we cannot take advantage of such instruments, but we need to understand that thoroughly.

One question to ask always: How is the company making money out of this? If you probe with this mindset, you will see things that were designed to be overlooked by the investor. For mutual funds, I know the answer is very transparent – through the Gross Expense Ratio in most cases.

Load than churn- Grow vertically, not horizontally

Anyone who has done day trading knows the extremes of churning. However individual portfolios are also susceptible to churning by high-beta fund managers, or the investor himself as he loses patience to hold on to a particular investment.

With 3-4 mutual funds in the portfolio, it takes a lot of patience and courage to stick to them when your investment brain is screaming – Do Something, its been a year!!

The best way to get around this very humane behavior, is to divert your attention to saving and investing more, rather than changing your investment vehicles.

If you have to do something, take a look at your monthly budget, analyze your spending and see if you can LOAD up the existing investments rather than CHURN them.

Conclusion

The above steps address both the fear in the minds of investors and also gives them a simple formula to allocate their investments with complete understanding.

My investments are diversified in the following manner, and are stacked in decreasing amount of risk.

  1. Cash in the bank, money markets.
  2. Stock Mutual Funds – passively managed.
  3. Stock Mutual funds – actively managed.
  4. Public REIT Index funds
  5. Private REIT – Fundrise
  6. Real Estate holdings
  7. Unit Linked Insurance Plans (well understood ones)

This is as much diversified as it can be.

  • #1 and #2 provides enough cushion.
  • #2, #3 and #4 are volatile and longer term, but liquid. 
  • #5, #6 and #7 are the only non-liquid investments, and I am careful to maintain the ratio of such investments to less than 50% of overall net worth. Only real estate can skew this ratio, since this is a high value and often appreciating asset.

Put your best foot forward with diversified shoes, but ones that you feel comfortable in.

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