The first steps toward financial health

Tuesday, October 22nd, 2019

I have started writing about personal finance at the daily publication Broadsheet. This first piece, reposted here with their permission, is on taking the first steps toward financial health:

It’s easy to feel overwhelmed when we start to think about getting our finances in order. We are pressured by overeager relationship managers at the bank, offered all sorts of gyaan from relatives and friends. However, here’s the upside: it gets us thinking about investing in the markets and putting aside money for the future. But before you act on any of that advice, here are five things you need to do first. 

One, follow your money: It’s payday and you finally have some cash in the bank! Cut to 15 days later and you really have no clue where all that money has gone. Financial health begins with knowing and controlling how you spend your money. It may sound tedious, but it’s actually not that hard. Here are a few ways to do it: 

• Get an app like Walnut or ET Money to track your cash flows.
• Or do it old school: create a simple table in a journal or use an excel template to categorize your spending. Prioritize what is essential and try to reduce your spending on the rest.

The bottomline is that you have to find a way to save in a consistent manner—month after month. And you can’t do that if you don’t know how much you are spending and on what. And unless you are already earning more than you can spend, there will be sacrifices—major or minor.

Two, clear your credit card bills: Did you know that paying down credit card debt is in itself a form of investing? A low interest credit card starts at an interest rate of 18% per year—and that debt compounds to a much larger amount over time! So if you are carrying Rs. 10,000 on your card and don’t pay it off for 5 years, you owe Rs 22,877 to the credit card company—that’s far higher than any return you would reasonably get if you had invested the same amount in equities or mutual funds. Simply not owing that amount is an investment in your financial future.

Three, create an emergency fund: Here’s the hard truth. You need to keep roughly 6 months of living expenses in a fixed deposit. This is a must-have buffer to survive any family emergency, health crisis or the loss of your job. Even if you think you are protected from any such misfortune, think of it as learning a useful lifelong habit—i.e to save. This is especially important if you don’t have any savings as yet. Just building that fund will force you to put aside as much money as you can. No, please do not dip into that honey pot to fund that trip to Sri Lanka. 

Four, get adequate insurance: The first rule of making money is to not lose money. Insurance is a must to protect you from unplanned financial shocks. Here are a few essentials to keep in mind:

• We tend to put health insurance at the bottom of our expense list—especially when we are young or between jobs. But that is a serious mistake. Unplanned medical emergencies are the leading cause of financial catastrophe around the world. Major surgeries cost lakhs of rupees—and with a more serious condition, the bills can quickly pile up. Therefore, if you are in your twenties, take a cover of at least Rs 15 lakhs. If you are in your thirties (with a kid, maybe), ramp up to a minimum cover of Rs 20 lakhs per member of your family. 
• Opt for a term insurance—which is essentially a life insurance that offers cover for a limited time—and only pays if a death occurs within that period. The benefit of such plans is that they are substantially cheaperthan other policies. If you have anyone who is financially dependent on you (kids, parents, spouse), then you must invest in enough coverage so they can cover their basic expenses for at least a decade—in case you are not around to provide for them. 
• Finally, it’s best to not mix insurance with investment. I am talking here about ULIPs and endowment plans—both carry exorbitant charges and give you neither enough return on your investment nor sufficient coverage on your insurance. You can learn more about why they are a bad idea hereand here.

Five, plan wisely for taxes: I recommend my clients think of taxes as a separate bucket from investing. Sure, there are many avenues for an investor to save taxes but here’s the bigger picture: tax-free deductions are typically limited to Rs 1.5 lakhs a year. So if you already have insurance and a provident fund, you may gain no further benefit by investing in more tax-saving equity schemes. 

So what’s next? Once you’ve set yourself on the path to financial planning, it is best to speak to a trusted advisor. Ask friends and family for recommendations. A good advisor will create a comprehensive plan for your investments that considers your time horizon, your ability to withstand losses and ensure that your portfolio is diversified across multiple asset classes. 

Final bit of advice: There is no better teacher in investing than experience. Start small, maybe with a systematic investment plan (SIP) in a mutual fund, and build over a few years. There are plenty of options available, but it’s best to stick to simple, low-cost mutual funds that have performed consistently over long periods of time. You can look at the ratings of the funds in the Mint 50 or Morningstar’s Analyst Ratings as a starting point to help narrow down your choices. How do you pick the right fund for your needs? Well, that’s a pretty big topic which I will tackle on another day.

Disclaimer: Please note that all the information mentioned above is for educational and informational purposes only. Please consult a qualified financial advisor prior to making any investment decisions.

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