Terms of reference for money management

Published: May 9, 2015 at 9:12 am

I had a chance to speak to the employees of a Hyderabad based mobile tech company. I wanted to build that talk around the terms of references needed for money management. I could think of three crucial objectives:

  1. insurance
  2. inflation
  3. peace of mind

I  was able to cover the first two points but could not get to ‘peace of mind’. In this post, let us try and discuss it.

Type ‘comfort zone’ in Google and you will find a series of articles and imgaes  which will tell you step out of your comfort zone.

With respect to a career or achieving things, I fully agree. “We must find our comfort zone and leave it” (source unknown).

However, when it comes to money management, I think one needs to stay well inside one’s comfort zone, after recognising the importance of insurance and inflation.

For regular readers and personal finance aficionados, the first two terms of reference will be quite familiar. Nevertheless, let us run through them quickly.

Insurance

Emergency insurance*, life insurance, health insurance and accident insurance.

* with a cash stash

I have written enough about this and do not wish to say any further. If you are interested in knowing more, you can look at:

Notes on financial fortification 

Inflation

The objective here is quite simple. Inflation devalues money. So when you have an expense in future, you need to ensure you have enough money to be able to afford it.

Factoring inflation is the key. How you choose to beat inflation is up to you.

You can either invest in equity and hope to grow your investments at a pace higher than inflation.

Or you can use fixed income (money-back policies, FDs etc.) products and invest more to compensate for a return lower than inflation.

Which bring us to ‘peace of mind’ or comfort zone.

Note: inflation has an impact on short-term goals as well. However, it is a bad idea to try and beat it with better returns. Too risky.

Use this tool to understand the importance of beating inflation with returns and/or with capital

Visual Goal Planner

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Peace of mind aka Comfort zone

Once you recognise the importance of the first two terms of reference, you need to choose instruments for implementation.

For insurance, the products are rather simple: pure term life insurance, medicalim, accident insurance policy, some rainy day money kept in SB account (for a start) should do.

Inflation is a tougher cookie to handle.

For people (like me) who were fortunate enough not to invest in any product before coming to know about inflation, the choice is simple:

equity (stocks) is the only instrument with highest liquidity and potential to beat inflation over the long term (min 10 years)

The simplest way to get equity exposure is via an equity mutual fund where a firm collects money from individuals and assigns a person to manage it by selecting the right kind of stocks.

One can also buy stocks directly and manage them, but that is a tougher proposition, in terms of digesting emotional upheavals associated with our decisions and market movements. Choosing equity funds is a simpler and relatively less stressful option.

If you wish to beat inflation with fixed income, then that is your comfort zone.

The trouble is with people who purchased and got used to fixed income products before understanding the importance of factoring in inflation. They have developed a sense of comfort, without understanding the nature of the financial goals they are planning for.

It would be disastrous if they wish to remain in their comfort zone of fixed income. That is the point of this post:

The terms of reference should be considered in the order in which is has been listed:

  1. Insure your financial life
  2. Factor inflation for financial goals
  3. Choose how to beat inflation within your comfort zone.

The plain truth is that most of us cannot beat inflation with fixed income, even on paper. We simply cannot manage to invest the amount necessary.

Hence, equity exposure is mandatory for most people. The amount of equity exposure can neither be too low (will not make an impact) or too high (too risky), but can be set to something comfortable ( I like 60% for long-term goals).

The other debate is stocks vs mutual funds (or stocks+mutua funds).

As long as inflation is factored in, it does not matter you do, as long as you comfortable about it.

Personal finance is all about peace of mind, but with basic fortifications in place.

Building a comfort zone cannot and should not be done overnight. It will typically take a few years to decide comfortable equity allocation (including 0%), whether to choose mutual funds or direct equity or a combination of both.

A comfort zone must be built with introspection – on what we think will work. Not what others think will work!

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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6 Comments

  1. Somehow I am not convinced. Basically you are transferring inflation risk to equity risk. And that is another beast. Think you were a Nikkei investor in 1980s. You will still be waiting to get your money back! Also, in capital markets, equity returns are generally tied to the rate of technological progress (basically GDP growth). Do you think we can sustain this growth for decades (during our investment lifetime) or our market returns are basically easy foreign money (due to easy monetary policy followed by global central banks). Only time will tell…

    With regards to debt, yes, long term bonds will get devastated due to inflation. But the short term bonds generally track the interest rates of the economy. And interest rates of economy are set based on inflation. So investing in short term debt would generally get you the inflation return. You might not beat inflation but you will atleast get inflation return. This is different from just putting money under a mattress. Like you mention, saving a bit more and investing in short term debt might be a safer strategy rather than going all out in equites!

    1. No, I am not transferring inflation risk to equity risk alone. Equity investment implies, investing the right amount in a diversified folio. Without which it means nothing. Any volatile instrument requires monitoring and suitable action, without which it will burn you. I have made this clear enough in my other posts.
      Getting zero real return with fixed income is a huge risk if life throws unexpected expenses at you. It will, for most people.

  2. Somehow I am not convinced. Basically you are transferring inflation risk to equity risk. And that is another beast. Think you were a Nikkei investor in 1980s. You will still be waiting to get your money back! Also, in capital markets, equity returns are generally tied to the rate of technological progress (basically GDP growth). Do you think we can sustain this growth for decades (during our investment lifetime) or our market returns are basically easy foreign money (due to easy monetary policy followed by global central banks). Only time will tell…

    With regards to debt, yes, long term bonds will get devastated due to inflation. But the short term bonds generally track the interest rates of the economy. And interest rates of economy are set based on inflation. So investing in short term debt would generally get you the inflation return. You might not beat inflation but you will atleast get inflation return. This is different from just putting money under a mattress. Like you mention, saving a bit more and investing in short term debt might be a safer strategy rather than going all out in equites!

    1. No, I am not transferring inflation risk to equity risk alone. Equity investment implies, investing the right amount in a diversified folio. Without which it means nothing. Any volatile instrument requires monitoring and suitable action, without which it will burn you. I have made this clear enough in my other posts.
      Getting zero real return with fixed income is a huge risk if life throws unexpected expenses at you. It will, for most people.

  3. Yes Arun I heard this argument in the 1980s when I started. Brilliant argument. By the time you win the argument ‘n’ is wasted, and inflation has won. Argumentative Indians.

  4. Yes Arun I heard this argument in the 1980s when I started. Brilliant argument. By the time you win the argument ‘n’ is wasted, and inflation has won. Argumentative Indians.

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