Financial Independence: A Guide for Beginners
This blog is mainly dedicated to those youngsters who have just started earning. It is very usual that in the beginning when we start earning, we tend to spend a lot on unnecessary things. The time to start building your assets starts as soon as you start earning. Therefore, instead of spending on things which we do not require, we should save that amount and start investing.
The question is what is financial independence? When do we know that we have become financially independent? The day when our money starts earning for us, and those earnings are enough to meet our expenses is when we can say we have become financially independent.
How do we Become Financially Independent?
Asset Building is the key to our financial independence. Asset building is a very gradual process and it can not be done over a short period of time. Investing should be disciplined and should be a way of life. It can be done either weekly, monthly, quarterly, half yearly or yearly, but should be done in a disciplined manner.
As we grow in our careers, our capacity to save increases and so should our capacity to invest. It’s a lifelong process which has to be done if we want a life which will sustain us even after we retire from our work.
If we invest in real estate and rent it out, then that rent is income generating assets for us. Similarly, when we invest in equities and we receive a dividend every year, then these shares are also income generating assets for us. Therefore, we should always invest in appreciating and income generating assets.
A depreciating asset, refers to assets that do not generate income. For example, a car is considered as an asset and we avail depreciation benefits on it, but is buying a car an asset or expenditure? The day we take the delivery of the car from the showroom the value of that car has already depreciated by 20% as it will be treated as a second hand asset. Therefore, we should always invest in appreciating and income generating assets.
There are basically four types of financial assets to become financially independent, which can be broadly categorized in:
Bank Deposits i.e. Fixed Deposits
Bonds (government treasuries or private bonds)
Mutual funds which includes SIP
The day when our money starts earning for us, and those earnings are enough to meet our expenses is when we can say we have become financially independent.
Let’s get started with the bank fixed deposits. These are low risks and therefore low on the return front also. Assuming that the fixed deposits pay us an interest of 6% p.a. and assuming that our inflation is at 7% then in that case we are losing 1% of our Capital due to inflation being higher than the fixed deposit Rates.
The main advantage of doing a fixed deposit in a bank is that it is normally risk-free and therefore gives us lower returns. I would normally advise an investor to have at least 10 to 15% of the size of its portfolio in fixed deposits. The reason for having the above-mentioned percentage as fixed deposit for contingencies which may arise anytime in these uncertain times.
Bonds are very similar to the fixed deposits which we do in the Scheduled Banks. The only difference between bank fixed deposit and bonds issued by various players, be it NBFCs or other private companies, is that they provide us with a higher rate of interest per annum.
Now the question which might be arising amongst you is why Bonds pay a higher rate of interest than the banks. The answer to this is that the chances of a Bank defaulting on its payment on maturity of fixed deposit is far less as compared to a company.The bonds issued by the companies are rated by the rating agencies such as CARE and ICRA in India. The higher the rating the lower the rate of interest which we will get per annum and vice versa. Therefore due to higher risk of defaults as compared to bank FDs, the bonds allure us with higher returns.
The third way to get to investing in the financial asset class is via mutual funds. The mutual funds are an indirect approach to investing in equities. When we opt for a mutual fund we allow the people who are expert in managing equity portfolios to handle our money. These mutual fund managers charge a fee to manage our money. I, however, am not a fan of investing in equities via mutual funds.
Now you may ask why I don’t advocate investing through mutual funds. The first reason being why should we pay a fee to a mutual fund for investing in a HDFC, HDFC Bank, TCS, Infosys, reliance etc. The second reason being that for my money I am the best person to decide as to where to invest. The third reason being is that when we annualize the commission which we pay to a mutual fund grossly diminishes our return on investments. There might be many of you who might be thinking that the markets have risen on an index basis by 10 to 15% but our returns are only between 5 to 8% when we invest in a mutual fund and the reason for this under performance can be attributed to any or all the above-mentioned reasons.
The most favored mode of investment for me is direct equity investing. We can do direct equity investing in three forms. The first being the spare amount which we have can be invested in the equities on a lump sum basis. Now here we can make a basket of stocks in which we would like to invest and allocate a certain percentage of our portfolio in each stock in which we want to invest in. The second being the SIP method, i.e.: the systematic investment plan. There are two ways of doing an SIP. The first being that we allocate a certain percentage of our spare funds to be invested every month through a mutual fund and second being that we do a monthly SIP in order to accumulate the stocks which we want directly from the market. In both cases the investor allocates a fixed dedicated sum on a monthly basis either through mutual funds or direct equity investing. The third form being investing in exchange traded funds i.e.: ETFs. When we invest in ETFs there are two advantages. One being that we do not have to pay any exorbitant fee as charged by the mutual funds and the second being our returns are very much similar to the movement of the markets in percentage terms, whether on upside or downside.
In summary, I would like to state that we should have at least 10 to 20% of our portfolio FDs, 10 to 15% in Gold or Silver, and about 50 to 60% in equities. We can change the composition as per our risk appetite. As for me I am 70 to 75% in equities, 10 to 15% in FDs and 2 to 3% in Gold. The Balance spare cash which I have is for contingencies or any other opportunities which may arise during volatile and uncertain times.
Take a look at my courses in Amphy, including a beginners guide to financial markets and start developing your knowledge.
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