Monday, January 16, 2006

What is Financial Independence

What is this term and how does one decide that one is financially independent? I would refer you to a book with the title Rich Dad Poor Dad. In that the authors mention that sources of money can be divided into four quadrants. One is employment, the second is entrepreneurial or self employment, the third is investments and the fourth is business.

What one must know is that assets create income and liabilities deplete income. Hence what is a liability for you such as a loan taken from a bank is income for the bank. Paying interest through your nose is something that will bleed yiour finances. So much as that home theatre is attractive or that bike or car is something you must have, think less right brain or emotionally and more rationally. Claim your own mind first and then venture out into purchasing anything. Remember that this world is full of people whose sole occupation is to make you open your purse or whip out that credit card. Okay so all this makes the world go round but let it be at someone else's cost!

You are financially independent when your lifestyle is sustained by passive income, that is income which comes to you automatically without your having to work in any way for earning it.

How would this happen?
Let us take something like my pension from SBI. It was given to me when I retired from SBI and it comes to me month after month as long as I am alive. Or dividend that comes to me because I invested in some company shares. Or interest from fixed deposits that is mine because the bank does the work to allow me to earn from the money that I invested with them. The objective of saving money or investing it must be to build up adequate quantity of such income to become independent of working either for yourself or somebody else. At the end of it all, you have to choose how you want to live your life. Would you like to live like the stereotyped pensioner who appears to be perenially cribbing about prices going up and incomes not going up as fast, about how wants have increased and how there is never enough money etc. etc.? Or would you like to maintain your lifestyle even after retirement? This is a no brainer. I am sure you would all like to be in the second category.

Secret of Creating Wealth and Financial Independence

There is only one way and that is to choose an asset over a liability. Does that mean that you scrimp and save and deny yourself a decent lifestyle? No! Just take a conscious decision to keep aside a certain part of your gross every month for life. This itself will give you great financial power. During your early employment years, this can be a larger percentage and in the years to follow after marriage and children, this could be a lesser percentage. However, please try your best to ensure that this does not dip below 10% of your gross.

Young people are now paid better than when I started out and also have more avenues for spending money. The desire to spend is fuelled by glossy ads and a plethora of consumer goods and durables. The second is a misnomer! That TV that you purchased yesterday has been replaced by a better one that came in today and is 15% cheaper too. Luckily, thus far, Indians in general are a little more level headed than others and this has manufacturers sometimes tearing their hair in frustration. We tend to keep consumer durables longer and repair those that go out of order till it is impossible to do so or the cost of repair is almost the same as buying a new one. Hence, difficult as it is, pay yourself first or in other words invest in your security and that of your family first. Sorry for repeating this message but this has to become a part of your nature. Short term gain can create long term pain! Make a habit of saving some part of your income and creating security for yourself and your family. Let 15 to 20% of your savings and assets be in life insurance. Even if you feel that “Apne Na Koi Aage Na Koi Peeche”, put some money in life insurance as this will take care of future obligations and in any case will provide some money for a rainy day. Further, the younger you are the less premium you pay. You are therefore building up security at a cheaper cost. If you are employed there is some compulsory saving element in the form of super annuation or provident fund. Apart from this, start on a simple recurring deposit plan. Go get the best return. The Post Offices in India offer good rates of return and so also PPF. Some disadvantage in these plans is low liquidity. However, this is desirable for creating a long term asset that will grow anyway.

The thumb rule is to put only as much money in these that you can salt away without feeling the pinch! PPF has several advantages such as tax benefit and a decent rate of return. Further the interest is compounded which as you will see in my later articles allows faster accumulation of capital. Put aside 10% of your savings in these instruments. Create liquidity in the form of bank deposits and recurring deposits. Ideally 25% of your savings every month. This leaves around 45 to 50 % of your savings to invest in other assets.

For the rest of your savings, you can buy mutual funds, shares or anything else of choice. Choose something that allows you some liquidity and yet appreciates quicker than the more conservative investments. Be warned however, that risk and return are positively correlated. Higher the risk, the higher the return. If you have time to watch the markets and track your portfolio, invest directly in shares of your choice. However, if you do not have this luxury, choose an MF with a good record and put your money in a systematic investment plan. This allows you to put aside a small sum of money, say Rs 1000/- or more a month and invest in the share market indirectly. You have to pay a price for this in terms of fund management fee and so on. However, this is an option for those who do not wish to get into the markets on their own. With demat accounts available everywhere and online trading through your bank account, it is possible to buy even one share of say Infosys or Reliance or SBI and so on. Build a diverse portfolio of blue chips and put money in hot tips only to the extent you can afford to lose it all! If there is a windfall gain good for you! Rest in subsequent articles.

To sum up: -

1)Financial independence means that your lifestyle is sustainable without dependence on job or any other work on your part
2)Assets create income and liabilities deplete income. Choose assets over liabilities as far as possible
3)Invest 10% or more of your gross income to create financial independence for yourself. This has to be a triumph of mind over temptation!
4)Of your savings, put 15 to 20% in life insurance, 10% in post office instruments or PPF, 25% in creating liquidity such as Recurring Deposits or FD and the rest in either mutual funds or shares. Prefer blue chips over 'hot tips' and if you have to put money in a hot tip share, ensure that you put only what you can afford to lose!
5)Keep seeing the forum Krishna's Korner for discussions on topics covered in Krishna's Korner


(This article was written by Mr R.A Krishna, a school senior/alum of mine.He has more than 25 years of experience in the Banking and insurance sector and has worked with State Bank of India, Centurion Bank and other leading banks in India.He posts a weekly article on the School Alum site)

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