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What are the axioms of personal finance?

Posted on 03 Dec 2021
Author: Sayan Sircar

Tags: Behaviour

12 mins read
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There are some fundamental rules that you can use to navigate any personal finance scenario. This post discusses how to use them.

What are the axioms of personal finance?

We have all heard of the statement that personal finance is “personal”, i.e. it varies from person to person or person. However, there are a few underlying principles that you can use to answer the billions of possible personal finance query variations. The potential number of variations of questions where to invest, how much, how long, how to manage assets etc., is vast, and without a framework to analyse them, it will be challenging to deal with them on a case by case basis.

We borrow concepts from mathematics, specifically geometry, typically covered in school to understand how to go about this.

An axiom, postulate or assumption is a statement that is taken to be true, to serve as a premise or starting point for further reasoning and arguments. - Wikipedia

The entire subject of geometry is based upon the following framework:

Axioms that are fundamental like “It is possible to draw a straight line from any point to any other point.”
Theorems that are based on the axioms like the famous Pythagoras Theorem
An infinite number of applications and problems that are based on these axioms and theorems

The same applies to personal finance as well, where there are a few basic rules or axioms that govern everyone’s use cases. We cover some of them below.

You cannot predict the future

There are entire industries and professions out there that attempt to predict the future. They have many names and offer, for a “tiny” fee, offer to get you, the investor, higher returns than their competitors. A few examples of these are

active fund managers: a fund manager uses their skills in stock picking or investing to promise a return that is better than the market
stock picking services: these have existed ever since stock markets have. Nowadays, apart from brokerage houses and media, we have social media (WhatsApp, Telegram, YouTube or Twitter-based services) offering tips and recommendations
equity research reports written by analysts about a particular stock that predicts the target price of the stock
advice from mutual fund distributors, wealth managers and portfolio managers who promise higher returns or lower risk if you utilise their services

This article does not discuss the merits or futility of attempting future prediction as long as the investor understands what the service represents.

Compounding is important

Compounding formula

There are three takeaways from the compounding equation:

You need money to make money: how much you can invest every month will impact the principal figure. If you earn ten lakhs and save 10% vs save 40%, that is an automatic way to get 4x higher final corpus, with everything else remaining the same
You need to be invested for a long period: A portfolio growing at 10% on average doubles in value every seven years. This means that you need to have a proper plan for investments and do not pull out money randomly
You cannot predict the return you will get: you cannot predict the future and are a taker of returns given by the market. However, this should not be interpreted as “returns do not matter”. Returns are unpredictable and cannot be relied upon. Instead, the probability of reaching the target corpus is maximised by managing risk.

We cover compounding in more detail in this post: 12 mistakes that interrupt compounding: what to do instead

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Spend less than you earn

Annual income twenty pounds, annual expenditure nineteen nineteen and six , result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery - Charles Dickens.

As the above quote represents, continuously overspending will lead to disaster. People borrow either via credit cards or personal loans if there is a temporary budget crunch. However, living on debt will eventually catch up, where monthly interest payments on loans will not leave money for anything else. We cover debt payment here: Which debt to pay off when you have more than one loan?

Costs matter a lot

Returns are uncertain; however, costs compound. This cost consists of doing business (like running an asset management or insurance company with enough profits) and commissions to the salesman. Examples of commissioned advisors are mutual fund distributors and insurance agents. In addition, social media content with affiliate links that advertise products are examples of commissioned sales. High costs are inherent in most mutual funds, insurance-cum-investment products (like endowment products and ULIPs) and other investments schemes pushed by salesmen. A basic thumb rule is that the stronger the sales pitch, the higher is the commission being paid to them, which ultimately comes from the investor’s corpus. Investment advice is not free, and if it is offered for free, there is a commission involved.

In the compounding equation above, costs come from the ‘returns’ term and directly impact the final corpus. Here is a basic example of two investments with only a 1% difference in costs using an example of a 30 year in the same fund for a direct vs the regular plan

Gap of returns of Direct vs Regular funds as chart

Human capital is the most critical asset

Human capital

Human capital is an estimate of the future earnings potential of an investor, either from salary or business. As age increases, human capital will reduce; however, the investments create a portfolio that meets all financial goals.

An average investor who lacks the time or skills to track markets or pick funds/stocks should aim for

investing in low-cost passive investments: Which funds should I invest in?
devote their time and energy to increasing their income (see chart below)

Compounding example

Over 30 years at average 11% returns,

₹ 1 lakh/year fixed SIP yearly leads to a ₹ 2.21 crore corpus
₹ 1 lakh/year SIP increasing at 10% yearly leads to a ₹ 6.04 crore corpus
₹ 1 lakh/year SIP increasing at 15% yearly leads to a ₹ 12.02 crore corpus

The investor needs to figure out what is more likely to be achieved:

putting in extra efforts in chasing better returns
upskilling to increase their income

We discuss human capital in more detail here: Your human capital, not investment returns, is your biggest wealth creator.

Your attention span is finite

Our time and ability to multitask is limited. Also, we have different demands on our time at various life stages.

Early career provides more opportunities to focus on trading and stock/fund picking and following a more active investing style
Mid-career with family obligations implies less time is available to track markets and investments actively. Investors will be better off investing in passive investments via monthly SIPs and yearly/event-based review and rebalancing
Once retired, the focus should be on having a straightforward portfolio that is easy to manage for both spouses as age increases beyond 70

Inflation is a silent killer

Inflation is an important input to goal-planning in an economy where prices are rising overall. We can use the rule of 72 as a convenient mental shortcut to understanding the impact of inflation.

Rule of 72

The rule says: Rate of doubling * Time in years = 72

Rule of 72 lets us quickly calculate the impact of inflation over time. Using the rule, we can see that

the purchasing power of money halves every ten years at 7% inflation. For example, one crore worth today will be worth 50 lakhs in 10 years and 25 lakhs in 20 years
a lump sum payout, say from an insurance plan, is worth around four times less in today’s money if received in 20 years
if you need one lakh/month in living costs in the first year of retirement, that will be two lakhs/month in ten years and four lakhs/month in twenty years
if a UG college degree costs 20 lakhs today, it will be 4x that, i.e. 80 lakhs in 14 years at 10% inflation for a 4-year-old today

Inflation: the impact on your goals and how to choose assets that beat it

The above examples show the danger of thinking linearly when money is involved. For example, any goal planning that ignores the effect of inflation will lead to inevitable failures when it is time to spend the money. Similarly, investing in insurance plans that give a fixed return over life will lead to getting smaller and smaller amounts in real terms that will be useless in the later years of retirement. The actual calculation is an application of the compounding formula like this:

Cost after N years = Cost today * (1+Inflation) ^ Time

Since goals must be set using the S.M.A.R.T framework, building inflation into the target corpus amount is crucial.

Safety nets are vital

Imagine what the career of a trapeze artist looks like in case they insist on performing without a safety net.

The safety net in case of our financial goals are the following:

An emergency fund with 6-12 months of expenses
A term insurance policy (unless you are retired with no income)
A health insurance policy (separate from the company-provided one, if any) for 10-15 lakhs as a base policy with a 50-100 lakhs super-top up
A personal accident insurance coverage to safeguard against accidents where you do not die but cannot earn
No high-interest debt like credit card or personal loans

We cover this in more detail in this post.

Diversification is a free lunch

Diversification concept

Diversification, or not putting all your eggs in the same basket, is the only concept in finance where you get a “free lunch”. The basic premise is that different assets move in different directions simultaneously, and overall each asset moves up with time. If you combine this concept with rebalancing, you have a framework that allows you to buy low and sell high consistently.

Pay off loans before investing

Except for loans taken to purchase assets or knowledge, like home and educational loans, you should aggressively pay off all other loans. Money saved in not having high-interest payments is guaranteed and higher than any other form of investment. You should not be investing at all if you have a credit card (30%+) or outstanding personal loans (10%+).

The conversation becomes tricky when discussing housing loan pre-payment since that loan rate is considerably lower than credit cards and may be beaten over long periods via investing. We have covered this topic in these posts:

Understand your investments

Investment products can be both simple and complex, can behave in unpredictable ways and may come with a lot of fine print. A few examples will make this clear. Do you understand:

the exclusions of your health insurance policy?
the circumstances under which your debt mutual fund may restrict access to your money (under portfolio segregation rules?
that there is still risk if you invest in index mutual funds and how to deal with that risk? Portfolio rebalancing during goal-based investing: why, when and how?
the circumstances in which you can withdraw from provident fund?
how tracking error and TER works in International mutual funds?

The investor need to perform a good amount of due diligence before choosing the investment, using the rules in this post as well as review the investment itself regularly for any changes.

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