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Tuesday, November 24, 2009

How to generate income and build wealth

It is important for all investors to clearly understand the difference between income generation and wealth building. Confusions arise since both income and wealth are classified in terms of money: Mukesh Ambani is a multi-billionaire; my nephew works for a multinational company where his CTC (cost to company) is Rs 15 lakhs per year.

Having a substantial income - whether from salary or business - doesn't necessarily make a person wealthy. Why? Because building wealth is a well thought out process that needs to be followed with intelligence and discipline.

Many young investors think that the stock market is a place where one can get rich (read: wealthy) quickly without spending too much effort. All you need is some luck and a few good tips. Every one has a cousin or a friend that has made a killing in the stock market.

Most older investors shy away from the stock markets. They look upon it almost as a vice den, where unscrupulous people take part in nefarious activities which are much worse than gambling in a casino. They all have a colleague or relative that has been reduced to penury by losing all his savings in the market.

Both views are extreme and do not help in building wealth. The younger group find their thrills in the stock market - where they lose as much as they gain, and look down upon bank fixed deposits and post office monthly income schemes as boring and old fashioned. The older group stick to risk-free fixed income streams that get eaten away by taxes and inflation. Neither end up being wealthy.

To build wealth over the long term, a system that combines these extreme views needs to be developed. The simplest and most effective way is to have an asset allocation plan. A certain portion has to be allocated to equity shares to hedge against inflation and taxes. One also needs to allocate a substantial portion to fixed income avenues, that can generate a regular stream of income to supplement the salary or business income.

Think of income as a cash inflow that is spent on bills, home and car monthly installments, eating out, watching movies, buying stuff at malls. If one manages to save something after all these 'important' expenditure, only that saving can contribute towards building wealth.

So one needs to have a plan that works backwards. First of all, have a goal about the amount of money you will require at different stages of your life. Your marriage, children's schooling, aged parents' medical expenditure, family holidays, your old age retirement requirements.

Then calculate how much you need to save every month to invest it as per your asset allocation plan to achieve your various financial goals. This amount - it need not be an exact figure as a rough estimate would suffice - should be taken out of your pay check or business income every month before you begin your monthly expenditures.

This may sound like an easy plan to implement, but believe me, it isn't. It would mean a lot of sacrifices - both small and large. A simple 'thali' dinner instead of one at a fancy restaurant; a DVD watched at home instead of a family outing at the multiplex; a holiday in Goa or Puri instead of at Malaysia or Mauritius; buying a 5 years old car instead of a spanking new one from the showroom.

At the end of the day, it is your mindset and prioritisation that will determine whether you have 'enough' money and can retire a wealthy person.

Related post

How to reallocate your assets


SG Money Mind said...

Living frugally within your means and consuming what you need and nothing beyond that, are the first steps to be wealthy both in monetary terms as well as in happiness.

In a materialistic world so many people attempt to jump to the next step of savings and investment overlooking this important first step.

Another set of people thing owning every gadget/durable goods as a "need" and still think they are frugal, which is not true in my view point.

N said...

Just to add that if you have all you need (not necessarily all you want, but all you need) you are already wealthy. Accepting that along the way can help you ride the ups and downs.

Subhankar said...

@SGMM: Those are words of a wise investor.

There is a fine line between 'need' and 'want'. Where you draw the line will determine the level of your happiness.

@N: Some day, the basic needs of the majority of our population in the rural areas will be met. The process has been started, but there is a long way to go.

That day will make our nation truly wealthy.

Rishi said...

Thanks for your wise words and effort to share your experience. Let me take this opportunity to share my little experience so far with investing.
If i have a plan/goal associated with an investment, asset allocation, re-balancing, exit strategy are clearly captured and bigger picture is available [Let me use the term "system" as you have pointed out], it helps me to remain within the boundary of the system and not get carried away.
If a system is not created, i could not follow a clear exit/entry strategy along with how to allocate. When the going was good, i thought i should hold on for longer term and when the going was bad i thought i should save at-least the remaining capital. Without the plan i missed out on exiting at higher levels and buying at lower levels.
With the system, the amount of money needed & amount of money to invest in is quite clear. Once the desired limit is achieved, the exit becomes easier. Any substantial achievement above the desired limit can be treated as a great reward/bonus for the system and patience.
The bonus can be judiciously utilized to generate free cash inflow - way towards wealth.
Once I create the system and start working towards it, I realize and could not agree more on your last point about sacrifice, I have to do a lot to stick to the plan and really achieve it. But knowing the bigger picture and want to achieve has kept/will keep me going.

"Suffer not to suffer"

Jasi said...

@Rishi, you know this system you have spoken of sounds too theoretical to most of us. So, it would be very beneficial to the community if you can share your system and how you go about implementing n sticking to it :)
@Subhankar sir, once again, words of wisdom :) Thanks a tonne

Rishi said...

Let me quickly put up a example here.
As Subhankarji has pointed out, the first step towards creating a system is to have a asset allocation plan.
Divide the asset allocation plan into 3 steps.
1. Identifying a Goal
2. How much money is needed to achieve the goal.
3. Identify the investment instrument, based on your own risk taking capacity and arrive at asset allocation.

Final major steps are re-balancing the asset allocation and sticking to the plan.

Now lets move on from theory and see an example.
Assuming, X is just married and planning for a kid. X is interested in generating wealth for his family.
As per the extreme views Subhankarji mentioned, X can invest in stock market to make it BIG or run away from stock market based on previous worse experience and stick to debt instruments.
Instead X plans to create a system.
1. Goal - To generate CASH to provide good higher education to the kid after 16yrs the kid is born. So assume 18yrs from now.
2. How much is needed?
Current Value - Say 500,000.
Now one has to take into account the inflation[as Inflation is KING] - say 6% annual and calculate the future value[FV].
Roughly the Future Value comes to 2000000. [20lac]
X knows 20lac is what he wants after 18yrs.
X figures out investing an amount of roughly Rs.2000@12% would yield 20lacs in 18yrs. [FV function of the excel sheet can be used to arrive at this]

Note, the above figures are a rough estimate, i didnt run thru the formula to arrive at the exact figure.

3. Now X, can identify the investment instrument based on his/her own risk taking capacity and the term of investment into account.
This is where, as Subhankarji pointed out, X needs to use both the extremes and build the plan.
X, needs a 12% return and chooses to go with a asset allocation of 70-30 equity-debt [1400-600].
4. X has started investment and the equity value sky-rockets in a year' time, this is where re-allocation should done to maintain the allocation. The related link Subhankarji has put up can be read for more details.

Ok, where does the sticking to and sacrifice comes?
1. This is one plan, as and when start working on it, you will realize this is not the only one you are looking for. Subhankarji has pointed out a few examples.
As and when you include all the plan and most of your income goes into the system, you will start feeling the pinch.
Investing 2000 every month is easy, but the same 2000 might eat away your weekend movie, eating out with your family. This is the sacrifice you and your family members would be requiring to do at times.

Note : This is purely an example and should not be treated as an investment plan. Please do work on your own system based on your need.

Hope this helps.


Subhankar said...

@Rishi: Appreciate your comments and the detailed response to Jasi.

You are wise beyond your years. Just stick to your financial plan, and tweak it only if absolutely necessary.

@Jasi: Thanks for the kind words.