There is No Fate But What We Make: Ten Steps to Wealth Creation

Thursday, October 20, 2005

Ten Steps to Wealth Creation

Disclaimer: I am not rich. Read and follow at your own risk.

It doesn't take ten steps. Just a single step - Start your own
business. Look at top 500 wealthiest people in the world.
Except for those who inherited wealth, they got rich by owning
businesses ! Yes, that includes Bill Gates, Warren Buffet,
Sam Walmart and Azim Premji.

If you want to be a salaried person and don't want to own
businesses, you can still create wealth - by owning business
vicariously i.e. by owning shares of companies.

Follow the steps below.

1. Write down your goals that require money.
These are usually - Retirement, Education, Marriage, Car etc.
Each person will have his unique financial requirements.
Have you heard the saying, "If you don't know where you
want to reach, it doesn't matter which way you take!"
It's amazing to see people harping about this stock or that
policy without having figured out what their goals are.
Stop being one of those guys !
2. Write down your financial assets.
These are Bank FDs, Shares, Mutual Funds, Insurance policy
surrender values, Gold, PPF balance etc. Don't include "stuff"
(like Car, TV, Home that you need to live in).
3. Write down your liabilities (loan, credit card dues etc.)
4. Take cover - life insurance, medical insurance, accident/death
and disability. Cover costly "stuff" - home and belongings,
professional practice (for doctors and lawyers). Cover self and
those financially dependent on you.
Life cover is only for those who have financial dependents.
5. Pay off any debt whose interest is higher than what you can
earn in the market over the term of the loan. Meaning, if you
have credit card loan at 25% interest for 2 years, pay it off
before you start investing. Same with personal loans.
Home loans are an exception because of the tax
breaks. A home loan at 8% is effectively at 5% since you get a
tax break. Let's say the loan is for 15 years. Can you get returns
better than 5% over a period of 15 years ? Yes ? Then keep
the home loan. Don't prepay.
Otherwise, pay off loans before investing. If you are the type
who borrow to invest (that too in shares!), you are in the wrong
blog. I have wasted your time.
6. After factoring in the liabilities, calculate what your monthly
outgo for those liabilities is.
7. Find your monthly expense. Better, take your yearly expense
and divide by 12. If you don't know your expense, this is very
bad. Start noting down your expenses and find it.
8. Put the amount needed for each of the financial goals.
Also put how many years you have before that goal.
For example, you are 22 and you want to retire at 50
with 1 crore. You have 28 years to the goal.
9. Now here's the big gyan. There is some thing called
Asset Allocation Plan (AAP). I don't know why AAP works.
But Nobel Laureates and smart MBAs believe in it. I take
their word for it. The gyan is: The best way to meet
Financial goals is to create AAP.
For every financial goal, make an AAP.
What is AAP ? It is simply a way to distribute money across
various asset classes. What are asset classes ?
These are the various types of financial instruments - shares,
bonds, precious metals like goad, real estate and good old cash.
The theory is that the distant your goal is, the more you should
be in equity.
The closer the goal is, the more you should be in cash. Bonds
are for intermediate goals. It doesn't mean that you should 100%
in shares for long term goals. This is where allocation comes in.
Here are the rules (roughly put, without the mathematics and
customized to Indian conditions):
(a) Money for a goal which is less
than 2 years away should be in cash (cash can be in bank spread
across branches, under the carpet, or in Liquid Mutual Funds).
(b) For goals between 2 and 6 years away,
keep 80% in bonds (Post Office/Bank FDs, RDs, Debt Mutual
Funds) and 20% in equity (shares or Equity Mutual Funds).
Decrease equity by 5% every year and move it to
bonds. When you are two years away you will be 100% in bonds.
Now treat this as case (a)
(c) For goals more than 6 years away, stay 80% equity, 20%
bond. When you are six years away, treat as case (b)
10.Now some mathematics. You do remember what a compound
interest is, right ?
Consider long term equity returns as 14%. Debt returns as 7%.
Now apply formula to calculate what you need to invest every year.
Divide by 12 to get the monthly investment amount. For example,
you need 10 lakh for your kids education
in 15 years. Consider roughly 14% return. If P is invested every
year for 15 years, here's the equation:
P * [(1.14) + (1.14)^1 + (1.14)^2 + (1.14)^3 + .....
+ (1.14)^14] = 1000000
Solving this (you can use Excel or you ask your geek friend), you
get P = 22808. Monthly investment is 22808/12 = 1900.
So now you know by investing about two thousands a month into
equity, you will have 10 lakh in 15 years.

Do the above exercise for all your financial goals.
Now you know how much you need to invest every month
and in what kind of assets. Obviously, you need to
make sure your investment + expense is equal or lesser
than your income. If not, reduce your expense. or, lower
your financial goals.

Once a year rebalance your portfolio so that you don't stray
from AAP. Suppose you started
with 60% equity and 40% debt. But due to market going up,
your equity portion has ballooned and has become 80% of
the portfolio. Sell some equity and move to debt so that
you reach 60/40 split again.

I started this post by creating a dichotomy - salaried person vs.
business owner. But in reality, even a salaried person is a
business owner. A salaried person is in the business of
selling time and expertise. In business, products need to
move up the value chain. Similarly as an individual, a salaried
person needs to move up the value chain. That's why Warren Buffet
said investing in yourself gives the best ROI. In other words, if you
want to create long term wealth, start moving the product
(i.e. yourself) up the value chain. Get additional training/degrees
and experience. Money may get stolen, share market may crash
but your knowledge and expertise will be with you. And that is
the real wealth you should be after.

6 Comments:

At Thursday, October 20, 2005 6:57:00 AM, Anonymous HoliDevil said...

It was a great stuff.

Where will you put SIP which gives you a return every month ?

T C

 
At Thursday, October 20, 2005 8:38:00 AM, Blogger Charu Majumdar said...

in SIP, you invest every month..

 
At Thursday, October 20, 2005 8:47:00 AM, Blogger Charu Majumdar said...

It's the MIP (monthly income plans)
kind of mutual funds that give
monthly returns. Also, post office
MIS (monthly income scheme) can
give monthly income.

 
At Friday, October 21, 2005 1:22:00 AM, Blogger Anu said...

Very informative. I've discussed with you regarding investments , this post lists down all the points you told me and few more useful tips as well.

 
At Wednesday, December 28, 2005 6:32:00 AM, Blogger Wealth Creation said...

Well said, Charu

You have passionately put these points down in great detail. I agree with majority of your blog. If I only learnt one thing today, I would be happy to take away this knowledge of your shared wealth creation recipe.

 
At Saturday, April 30, 2011 5:50:00 AM, Anonymous rawengineer said...

this was a great piece, i think making money is everyones desire. But very few have the discipline to take action steps.

 

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