Financial Discipline for all.

Principle 8. Inflation

Inflation in layman’s terms is when you pay 15$ for a 10$ haircut you used to get for 5 $ when you had hair – Sam Ewing

WHAT IS INFLATION?

In simple terms inflation is nothing but rise in the general level of prices of goods and services.Or in other words , the value of your currency has gone down, and hence, you need more of it to buy the same quantity of goods.

HOW DOES IT AFFECT YOU ?

Let’s try to understand with an example-

THE BIRTHDAY BASH

Your wife has just delivered a sweet baby girl. One year from now, you are supposed to celebrate her first birthday. To make a budget, you enquire at the event manager about the costs and they say it would cost one lakh right now but they cannot guarantee the same price 1 year down the lane, because the cost of materials can go up. So you immediately put this money in a deposit that would give you 8% return by the year end. At the end of year 1, you have 108,000 with you. (Let’s ignore tax).

Now, its one year and you have to celebrate your baby’s birthday. Let’s assume that the inflation during the year was at 10%. That means the general price levels of all products have risen by 10% and hence your event manager is going to bill you 110,000 for a party instead of 100,000 earlier. So to arrange a party now, you have to incur an additional expense of 2,000 from your pocket. Why? Because, the money you have, has lost its value to the extent of 2,000. And, you could manage to make a return of only 8,000. If the general price levels moves up at this rate, it would cost you more than 250,000 to host your daughter’s 10th birthday! Had you managed your money to get a return of 10%, you wouldn’t have to spend that additional 2000 from your pocket.

That’s inflation for you – try to understand this vital principle in order to manage your money. So, if you are getting 8% on a 10 lakh Fixed Deposit and if the inflation rate is 8%, do you think you have gained a penny?  - No.  Inflation eats away the value of your money. The only way then, is to target a return on investments that would beat the rate of inflation.

REAL RETURNS

Many people while measuring the returns on their investment, forget to consider the effect of inflation. But that’s  not the correct way to measure returns. Returns calculated without considering the effect of inflation is called nominal return.  The return calculated after considering the effect of inflation is known as  real return. In addition, if you account for tax implications the real return would be even lower. So next time you have money to invest, keep in mind this ‘Real return’ concept. Real return is what you actually earn from investments -and not the advertised rate of return.

FORMULA FOR REAL RETURNS

To calculate real returns at any point of time use the following formula:


Taking figures from the above example – the rate of return (8%) and i is the inflation rate (10%)

  • 1.08 / 1.10 is 0.9818
  • 0.9818 – 1 is -0.01818
  • -0.01818 * 100 is -1.8181

The effective or real return earned on this investment is -1.8181% !

So even though your investment has made a return of 8% (nominal return). After considering the inflation rate (10%), the real return is a negative 1.81. Which means actually on maturity you did not make any money, infact your money has lost value due to inflation.

The Money Illusion

It’s very important that you learn the effects of inflation. For example – Let’s assume that you’ve got an increment of 8% in your salary. Your feel happy since, in real terms , your salary has increased by 8%. But that’s not the real picture. You have to find out what’s the inflation rate and deduct that from the 8% increment you got. Now, let’s assume that inflation is at 8%. That means, although you’ve got 108 in place of 100 earlier, the cost of goods that costs 100 earlier has also gone up to 108! Effectively, you’ve earned nothing! That’s money illusion. If you don’t account for inflation, you’ll be under the illusion that you’re earning a lot. The effect of money illusion will be more when inflation is unanticipated.

HOW DOES INFLATION AFFECT INVESTMENTS?

FIXED INCOME INVESTMENTS

Since fixed income investments are locked into a particular interest rate, your earnings may not keep up should the inflation rate accelerate. The principal you have invested also deteriorates in value if inflation rises steadily over a period of time.

For example -Lets assume that your tax rate is 20%. If you invest 2,50,000 that gives you 10% return, you will get 25,000 as return from which you will have to pay 20% tax .

  • Amount Invested = 2,50,000
  • Maturity Amount = 2,75,000
  • Interest Earned = 25,000
  • Tax on Interest @ 20% = 5,000
  • Net Amount in Hand = 2,70,000
  • Interest Earned = (20,000/2,50,000) * 100 = 8%
  • If the inflation prevailing is 7%, then Real rate of return/Inflation adjusted return = 8% – 7%= 1%

This implies value of money at your hand has increased only by 1% and not by 10% or 8% although you were under the impression that you were earning 10% on your investments.

STOCK MARKET INVESTMENTS.

Inflation and stock markets are negatively co-related. When inflation is high, it hinders economic growth of the country and such a scenario would definitely affect stock prices negatively.So as inflation increases, stocks tend to perform poorly.

GOLD AND SILVER INVESTMENTS.

The reverse would happen to gold and silver. Since stocks are not attractive, investors would naturally resort to gold and silver which are safe havens. Gold and silver go up during inflation. The reason is that, as inflation begins to creep up, the purchasing power of paper currency loses it value. Once paper currency has been invested into this precious metal, it will not lose its value as a result of inflation.

Investments in gold protects you from inflation. We will show you how with an example-

Let’s assume that you have Rs 1000 in currency. Inflation is at 8 % and hence at the end of the year, your 1000 is worth only 920. Instead, let’s assume that you bought gold. That move will protect your currency from losing value. How? When inflation goes up, the demand for safer havens such as gold will also increase (at least at the rate of inflation). Hence if inflation rate is  8%, the gold prices will also move up by 8% approximately.

In such a scenario, your 1000 invested in gold is now worth 1080 whereas if the money were held in cash, it would have lost its value to 920. So when you invest in gold , you maintain the purchasing power at the same level . Heavy investments in gold can be considered as a warning sign that inflation is coming.

That’s principle number 8! Inflation is a concept you cannot miss. The rate of inflation and the taxes you pay on returns have to be accounted for while measuring returns.

18 Comments

Principle 7. Don’t try ‘Get rich quick’ schemes.


“Let wealth come in by comely thrift
And not by any foolish shift.”

How about getting some money quickly? I have an offer- All you have to do is to join this site for a small fee of 1000 and then keep introducing others to it. For every person that joins by giving 1000 through your reference, I will pay 250 to you.  Give me 1000 subscriptions and take home 25000!! Sounds good? The truth is that such schemes don’t work.  If any of you were attracted to my scheme, definitely you’re lazy and have greed for money.

Think about it – Any scheme that offers a higher rate of return than normal returns given by bonds or debt funds should be carefully investigated. Why should someone pass you the trick to make big money? Or how can someone create a 500% or 1000% return in a year? If he really knew the trick, don’t you think that he would have worked for himself, make a lot of money and try to be with the likes of Mr. Bill gates and co?

Our 7th principle is simple and straight- Get rich quick schemes don’t work. There is no need to try such a scheme. Such schemes operating around the world are illegal. If you’re pressured by someone close (like your relative or friend), politely reply to them that it is not possible to join and what they are trying to spread is a fraud scheme. All scams that have happened in the past are known to have spread through the link of near and dear ones. Such schemes are a loss for the country. They distract people from doing productive work. Some countries have legally banned such schemes.  Unfortunately, there is no legal provision in India to curb such schemes.

WHY DO WE GET ATTRACTED TO SUCH SCHEMES?

Apart from personal pressures we said above, here are three simple reasons:

  • The guy who introduced the scheme to you has already played with your emotions and has got the best out of your greed for money. He has convinced you about the genuineness of the scheme by showing some certificates or bank accounts. You’re hooked to it.
  • It costs very little to start, hence you’ll take the risk.  You can join the race with a subscription and then it works through word of mouth. So, you think there nothing much to lose. As more and more people join on your behalf, you get rewarded, if you don’t get people to join, you’ll let go that small amount.
  • These schemes are marketed aggressively and it’s generally hard for an amateur to crack their arguments in favor of the schemes.

THIS IS HOW IT WORKS..

  • Typically- a well dressed guy with all the latest gadgets appears in front of you and would introduce the scheme. He will also show you proofs of money pouring into his bank account with little effort. He will pretend as if he has made a ‘smart’ choice by joining the scheme early.
  • The investment scheme typically would be to buy some products or tour packages for a small fee. Then, you’re supposed to pass on this message and bring in more people.
  • As more and more people join on your behalf, you become a team leader and starts getting a commission based on the number of people that has joined the scheme.
  • The moment the company doesn’t get new recruits or agents, the office of the company disappears.
  • The promoters abscond with the huge amount of money they compiled through subscriptions and the money of a wide group of people who joined last is lost.

EASY MONEY SCHEMES AROUND THE WORLD.

How it started –

These types of investment schemes are called ‘ponzi schemes’. The name is derived from the name of Charles K Ponzi, who masterminded the first ever fraudulent investment scheme.  He claimed that he could make 400% returns from arbitrage between Italy and US markets by investing in postal reply coupons. Needless to say, the scheme was a fraud one and people lost millions of dollars.

Read the detailed list of ponzi schemes from around the world at wikipedia page here.

HOW TO SPOT A GET-RICH-QUICK SCHEME.

  • Such schemes offer to make you rich in a matter of months without any hard work! In most of the cases, all these investors have to do is to bring in more and more investors. Minimum effort , maximum results!
  • In all probability the ‘corporate office’ of the company will be in a distant place from your country. They will show you photographs of the overseas office and also the official website and phone numbers.
  • They will pressurize you to join quickly so that you will be on top of the many others who will be joining the scheme soon. That way, you stand to benefit.
  • If you are still not convinced, someone may actually appear in front of you who would claim that he was working with a bank or some other organization but now, after joining the scheme ,  has left his job-  thanks to the “financial security” and “financial independence” the scheme has given.
  • All the meetings of the company will be hosted in big venues with lavish dinner and celebrations.
  • Most of these schemes will be advertised as a ‘risk free’ investments, and some sort of personal guarantee from the promoters would be given.
  • Sometimes the whole game starts with a simple sms to your phone  declaring that you have won millions in lucky draws conducted somewhere (?!!) by somebody (?!!) and in order to claim your money, all you have to do is to put some money as ‘processing fee’ to a bank account.

On searching the net, we have found countless illegal get rich schemes operating in india and abroad. The Reserve bank of India has published long list of companies who are engaged in ponzi schemes in India. The point is,  It’s your hard earned money and you just cannot put it into some illegal business expecting big profits. The onus of putting your money in right investments is on you.  If you cannot understand this simple fact, nobody can help you. Nobody can double your money in few months.

There’s No easy money!! As the saying goes – “If there is something too good to be true, it probably is” .

4 Comments

Principle 6: Never stretch beyond your limits.

Money will come and go; after all, you just have a life to live –why not live it to the fullest? Sounds perfect and positive, isn’t it? Unfortunately, if you are living your life like that, not everything is positive and perfect. You will realize the perils of reckless spending when you face a financial emergency. I have done it in my initial investing life– reckless spending – but soon realized that you cannot discount uncertainties in life. A sudden drop in my monthly cash flows turned my life into a nightmare. So, when i write my sixth principle, I have my own experiences to back it up!

The principle is not very hard to follow – never take money from your savings or borrow temporarily from your friend’s pocket to buy a little more luxury. Be it a slightly bigger house that caught your wife’s imagination or the latest electronic gadgets.

WHERE IS THE PROBLEM?

The lifestyle you want to maintain depends on three factors:

  • The circumstances in which you were born and bought up
  • The kind of friends you have
  • The place or community where you live.

Have you asked your parents about how they started their life? They din’t have a big car or latest electronic gadgets. They probably didn’t live in the big apartment or villa they’re living right now. They built everything brick by brick. It would have taken a lot of time, effort and disciplined life to get to where they are now. That’s exactly the way you should also start off. If you try to achieve all the life’s goodies in very short time, there’s every possibility that you’ll borrow a lot of money assuming that you’ve the ability to re-pay everything in 5 or 10 years and chances are that you’ll get into debt trap should there be an unexpected fall in your monthly income.

Another problem amoung youngsters is that spending habits are greatly influenced by their friends and colleagues. Bank balance doesn’t matter, the car or home doesn’t matter – what matters is the answer ‘yes’ to this question- Are you better off than your neighbor , friend , relative or colleague? If the answer is yes, you are confident, you feel happy. Or else – you stretch beyond your limits to maintain yourself the standard of living that your friend has! You will over borrow, over spend or do something to satisfy your ego. This category of people falls into the trap of personal loan providers. Personal loans are easy to get. There is less documentation and there are no restrictions on how you use the money. Since money comes in quickly with minimum documentation, you won’t mind the higher rate of interest.

Another reason for reckless spending is that these days, a lot of technologically advanced gadgets and appliances are introduced into the market that drives everyone crazy. Financial schemes are introduced by institutions which would seem like a very simple deal. These schemes are advertised in such a way as to lure customers. Such facilities tempt us to spend more. When you buy into such schemes, what you are actually doing is getting into the finance trap. I am sure 99% of people reading this would have done this in some form or other.

That’s principle 6 for you. It’s always wise to stay within your limits.

3 Comments

Principle 5: Cash reserves and idle cash.

Cash reserves are money kept aside as an emergency fund. We are discussing the need to keep cash reserves as our fifth principle because, this is one important idea which most of us neglect. When you set aside some money from your earnings to meet unexpected expenses, there are four advantages that automatically comes with it:

1. Financial safety.
2. It allows you to take advantage of a surprise financial opportunity
3. It creates a compulsory saving habit.
4. Since funds are kept in liquid cash or gold, it earns interest or appreciates in value.

We recommend to create an emergency fund that equals to 4 or 5 months of living expenses; however, you do not need to set aside this total amount in cash alone. It can be in short term fixed deposit or Gold etc..

HOW MUCH RESERVE?

That depends from person to person.

There are a number of factors that influences your decision on the quantum of emergency fund that needs to be created. Factors such as age, occupation, health condition, monthly EMIs, number of members in the family, other sources of income needs to be considered on a one to one basis.

1. AGE:

Depending upon how old you are, the emergency fund required keeps changing. As you grow older, the possibility of medical emergencies is also high. Hence, if your age is on the higher side (let’s say you’re 45 years old) you also need an emergency fund that’s higher than some one who is just turning 30.

2. OCCUPATION:

The style of occupation/business you do is another factor that influences emergency fund decisions. If you are doing a seasonal business or if your job has an uncertain future, you need a higher emergency fund. People living on commission based income would also require a high emergency fund.

3. HEALTH CONDITION:

More reserve funds may be required for a person whose health condition is questionable. The amount of insurance cover he has should also be considered while assessing his future requirement. Higher the insurance, lesser the need for reserve funds on these grounds. Again, if you have your parents or grand parents living with you, you might need to plan accordingly.

4. MONTHLY EMIs.

The volume of debt you have needs to be analysed to get an idea about how much EMIs you’ll have to pay a month. Typically, while creating reserve funds, an amount equal to 6 months EMIs should be kept aside so that in case of emergency, you don’t default in your loan payments. A clear track record of loan re-payments is absolutely necessary for your future financial needs.

5. NUMBER OF MEMBERS IN FAMILY.

If the numbers of members you need to support are more (say 7 members) naturally you need a higher reserve than what would be required if you have only say, 3 members in your family.

6. OTHER SOURCES OF INCOME

You can count on your other sources of income, if any, while creating a reserve fund. One time or casual income or credit card limits should not be considered in this group. However, you can count on the income of your spouse or other family members staying with you in case of emergency.

7. OTHER POSSIBLE EXPENSES.

You may also want to consider other expenses like possible higher education fees for your child who is about to enter college or a possible repair for your house. It all depends from person to person.

HOW TO KEEP RESERVE FUNDS?

Hundred percent of your reserve funds need not be kept in liquid cash. A portion of it can be kept in short term fixed deposits or debt funds and a certain portion in gold or easily marketable securities.

Any cash lying idle over and above your emergency fund results in a lost investment opportunity. You are not making your money work efficiently for you.

THUMB RULE

The thumb rule is – You should have enough reserves to meet all the expenses for 4 or 5 months plus some extra to meet unforeseen expenditure like medical expenses.

HOW TO SPOT IDLE FUNDS?

  • First estimate how much emergency fund you’ll require. (typically 3-6 months expenses)
  • Now see how much you have in your bank account plus cash in hand.
  • Deduct 3 or 6 months emergency fund. The balance is your idle fund.
  • This fund should be invested immediately. You can take up a systematic investment plan so that an amount gets invested automatically every month; or you can open an online trading account and invest in stocks or mutual funds at your convenience ; you can opt to open FD linked savings account so that any balance above a certain limit automatically earns interest at a higher rate and so on..

6 Comments