The below post is a work in progress and is far from perfect. There may be mistakes and I would appreciate everyone’s feedback to improve this very important article.
When we think about achieving financial independence, our instinctive idea is often about identifying ways to generate more income. While earning more is helpful, the key to building wealth lies in understanding how to invest and allocate our funds.
Getting wealthy is largely dependent on how we make our decisions about money.
Let’s dive deeper and understand the Earn → Spend → Save → Invest cycle.
Earning
There are two broad paths.
Do a job. Naval Ravikant says that one cannot get wealthy by renting our time [i.e. doing a job]. I do not agree. The formula is simple - Spend less than what you earn and invest the balance in an index funds. Let compound interest work.
Start a business. Ideally do something you deeply care about. Don’t start a business just to make money. If you love what you are doing then undoubtedly you will make tons of money.
Supplementary income streams such as interest from investments and earnings from real estate investments, can also bolster the top line. Another option is to explore the possibility of launching a side hustle.
But no matter how much we earn, wealth will be created when we understand how to put our money to work to generate more money.
Behavioral Finance
Before delving into the topic of investing, it is important to understand our relationship with money. It may sound counter-intuitive, but humans are often irrational creatures when it comes to finances. Our biases, emotions and occasional lack of self control significantly impact our financial judgements.
Two human behaviours have a disproportionate effect on our decision making.
Psychological / Emotional response - The two emotions of greed and fear largely govern human financial behaviour. Dan Ariely, in his book ‘Predictably Irrational’, illustrates through real-life examples how humans often make irrational decisions particularly in the field of finance. Emotions play a huge part in our decision making. We gladly jump into real estate frenzies and participate in the stock market bubbles.
Social response - Humans are wired to seek status. We want to keep up with the Joneses. We worry too much about the people around us and our decisions are influenced by our social circle. The world tells us that we should want a big house, a nice car, take exotic vacations etc. Nothing wrong about having these things. These are nice to have. All we need to ensure is that our pursuit of these possessions isn’t solely driven by a desire for social status.
Spending
We covered a bit about it in the social response paragraph above.
I admire people who reject what the world tells them what they should want. People who can look deeper and fight back against the trend. Those who can escape the culture bubble.
Two qualities which are worth a mention here.
Thrift is one of the four things that Charlie Munger recommends teaching our children. [the other three are duty, hard work and simplicity]. Thrift involves saving, avoiding unnecessary expenses and prudent financial habits over the long-term.
Frugality is a misunderstood quality. I am not recommending depriving ourselves something we want and can afford. I am suggesting not wanting too many things. It’s about simplifying our lives. Luxury brands generate less money by selling to the rich and make more money by selling to those who aspire to be rich. The social approval desire is indeed a strong one.
Finding other sources to get our pleasure from [such as good company, reading etc] will make us independent in every sense. Come to think of it, we aren’t actually free in this world. Phew!
In short, exercise self-control, be disciplined when spending and inculcate some good money habits.
Be wise.
Saving
When we subtract our expenses from our earnings we are left with some savings. We can invest this money [explained in the next paragraph] or deploy it in saving plans such as Retirement Saving Plans and Children Education Saving Plans.
When you choose any of these plans, please be aware of the fees, charges and expense ratios. A mutual fund that you buy from your savings plan will usually have a fee. Further, please consider the lack of liquidity and the tax implications.
These financial products were made for people who lacked discipline to save for their retirement / children education. If not for these instruments these people would have happily spent their money (and perhaps borrowed more to spend). Further, these products which help bank make more money are sold by evoking your emotional side - oh! this is for your old age / child’s education.
Personally, I think one can do better by investing in index funds or by holding a quality stock for long-term [10+ years]. Of course, one would need discipline and patience.
Some simple calculations of comparing the expected returns from saving plans vs. index funds can help us make the right decision.
A simple test to justify any financial decision is below:
If you cannot clearly explain why you are choosing one investment over the other then may be you are using words like diversification, superior returns, risk management as jargons. May be you are hiding behind your beliefs.
May be the fear factor is swaying your decision. Watch out for emotional decision making.
Investing
First Rule - Do not gamble.
Second Rule - Don’t try to “get rich quick.”
Let that sink in.
There are several investment asset classes. Each class deserves a separate post for a full explanation. Below, I am primarily expressing ‘my views’ on each class.
Equities (Stocks) - This represents ownership (share) in a company. Imagine lending your money to your brother who will use it to run his company and will share the profits with you based on your percentage of ownership. Stocks are by far the best investment from the risk/return perspective - provided we buy quality stocks and hold them for very long periods [10+ years]. It is important that we don’t overpay for our purchase. We can judge that by understanding ‘how to value a company and corelate it with it’s stock price’. I do not recommend individual stock picking for most people. It won’t be fruitful in my experience. Even Warren Buffet finds it tough to beat the S&P 500 index in the long-run. I believe buying an index fund (disclosure at the bottom of the page) will give you the best return over the long term. The S&P 500 has returned a historic annualized average return of around 10.26% since its 1957 inception through the end of 2023.
Bonds (Fixed Income) - You lend your money to the government or a company in exchange for periodic interest payment and the return of the principal amount on maturity. My view: Average Joe should avoid.
Mutual Funds - Professionally managed but may have high expense ratio. Most funds cannot beat the index ( I think the one’s that beat are in single digit. I have to verify this). there are 7000+ funds in the US and about the same number of listed stocks. One would be better off in picking a stock than a mutual fund. My view: Avoidable.
Commodities - These are physical goods such as gold, silver, oil, metals and agricultural products. One can buy them through the bank/broker. These are very cyclical and extremely volatile. One can get wiped out quickly. My view: Absolutely avoidable. The jewelry that you buy is enough of an investment in this class.
Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds but trade on stock exchanges like individual stocks. They typically have lower expense ratios compared to mutual funds. Slightly different from index funds mentioned above. My view: Avoidable.
Cash Equivalents - Liquid and low-risk investment such as certificates of deposit (CDs), Treasury bills (T-bills) etc. Good for parking funds in the short-term.
Currency - Forex trading is not an average Joe’s game. Stay away.
Crypto - Highly volatile and speculative. My view: Avoidable. Although the underlying technology - Blockchain - is mind-blowing and I am a huge fan of this technology. Blockchain and Crypto is slowly gaining traction. The movement refuses to die in spite of so much resistance. Coinbase is a listed company on US exchanges. It is a crypto exchange and the company is doing well.
Derivatives & Trading - Futures and Options are the most dangerous game. Control your gambling instincts. The downside is unlimited in some contracts. Absolutely avoidable. Similarly, I don’t recommend day-trading. One cannot value a company based on price movements. I call it speculation. Some traders may disagree but my opinion is based on data of successful traders, which is miniscule. Most humans need instant gratification and that’s why many prefer trading.
Real Estate - Buy a functional house for yourself ASAP. Do not overspend. [Remember the social and emotional angle in decision making mentioned above]. This is by far the biggest purchase of your life. Please be smart. From an investment perspective the additional properties may not be the best option for everyone. There are tenant issues, maintenance requirement, interest rate fluctuations etc. Besides, the historical average real estate returns are in the range of 5-8% as compared to about 10% for S&P 500. Real Estate vs. Index fund is a very polarizing topic and I recommend basing our decisions on data.
Key Takeaways
Spend less than what you earn and invest the balance in an index funds.
Think Long-Term. Compound interest is the eighth wonder of the world.
Buy your house asap and hold just one property (principal residence).
Simplify your life.
Understand your financial decision making. Your relationship with money. How you behave with money and your emotional state when you make financial decisions.
In Summary
Money is important. It solves a lot of problems and makes our lives comfortable.
We all must aim to achieve financial freedom. We will have our freedom when we can do whatever we want, whenever we want. It is a personal state when we don’t have to do a thing because we need the money.
Do simple things. History demonstrates that humans often avoid simplicity. Wall Street people try to make money by building complex financial products while Warren Buffet makes his billions just by reading company reports. We get attracted to complex because it is intellectually stimulating.
Getting wealthy is easy. It just takes time.
Books recommended - The Psychology of Money, The Richest Man in Babylon, Rich Dad Poor Dad.
PS: "Money is more like a vaccine than a performance-enhancing drug." It can prevent a lot of misery, but it won’t necessarily make you happier. - Derek Thompson
Disclosure: Views are personal and should not be considered an investment advice. Please do your due diligence. I do not hold any of the financial products mentioned, nor do I benefit if you purchase them.
Lots of useful information for someone dipping their feet in the real world and investing. Thanks for writing such a detailed article!
It looks like you've provided a comprehensive overview of various aspects of personal finance, including earning, spending, saving, and investing. Your emphasis on understanding the psychology behind financial decision-making is particularly important, as it influences how individuals manage their money.
Your advice on earning, especially regarding starting a business based on passion rather than solely for profit, is insightful. Additionally, your caution against emotional decision-making and the dangers of trying to "get rich quick" in investing are crucial points to consider.
Regarding investments, your breakdown of different asset classes and your personal views on each provide readers with valuable insights to make informed decisions. Your emphasis on long-term investing and the power of compound interest aligns with timeless financial wisdom.
However, while your views on various investment options are clear, it's essential to remember that financial strategies may vary based on individual circumstances and risk tolerance. What works for one person may not work for another. Providing a disclaimer about the importance of personalized financial advice tailored to individual situations could enhance the article's credibility.
Overall, it's evident that you've put a lot of thought into this article, and it offers readers a solid foundation for understanding how money works and how to build wealth. With some refinement based on feedback and continued updates to reflect changes in the financial landscape, this article has the potential to become a valuable resource for those seeking financial literacy and independence.