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Do you want to create wealth? This is how you should proceed step by step

This article discusses a no-shortcuts, step-by-step guide for investors who want to create wealth.

Do you want to create wealth? This is how you should proceed step by step


Posted on 22 Jan 2022
Author: Sayan Sircar
13 mins read
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This article discusses a no-shortcuts, step-by-step guide for investors who want to create wealth.

Do you want to create wealth? This is how you should plan for it

šŸ“š Topics covered:

Introduction

Everybody wants to go to heaven, but nobody wants to die. - Unknown

In the same way, we all want to be wealthy. We wish to know that name of the one investment scheme, mutual fund or future multibagger stock that will make us not only wealthy, but do it at low risk or worse allow some sort of risk since the investor ā€œcan take riskā€.

Real-life, unfortunately, does not work this way. However, a step-by-step plan can set you on the right path on the journey towards building wealth.

This article is the prelude to our previous article on How compounding works: the journey to a ten crore portfolio.

Here is the 10-sec version for those who do not wish to spend time reading the rest of the article: Invest 50:50 in an equity and debt mutual fund using some pointers from here. The result will be unpredictable, which should be acceptable since no planning is being done.

Step 1: Define wealthy

What does being wealthy mean to us is the first question that needs answering. Depending on where you are at your stage of life, this definition will evolve. An initial definition can be ā€œhave more money than I have todayā€. The end goal can be freedom, as described by Morgan Housel:

Moneyā€™s greatest intrinsic valueā€”and this canā€™t be overstatedā€”is its ability to give you control over your time.

Some alternative definitions can be:

  • I wish to have a house of my own, ensure that my family has a comfortable life irrespective of my income, and send my children to the best schools and colleges
  • I wish to have a stress free life as far as money is concerned
  • I wish to have enough money to have the same lifestyle as I see others having
  • I wish to have interests like travel, entertainment and expensive cars

Whichever definition you subscribe to, ultimately, it comes down to numbers, aspirations and planning.

Did you know that we have a private Facebook group which you can join for free and ask your own questions? Please click the button below to join.

Step 2: Be wary of inflation

Inflation is a silent killer and is often missed when planning what kind of wealth you aspire to have. Ignoring inflation also aids in misselling of products like insurance policies that offer you 10,000/month 10 years later. Alternatively, if a degree in the IITs cost ten lakhs today, and your child will go to college after 15 years, that ten lakhs has the potential of becoming a lot more. Similarly, a standard retirement planning starting point is to look for ā‚¹1 lakh/month in retirement. However, if retirement can start 30 years later for someone just beginning to earn and will last 30-40 years or more for someone just retired. The value of ā‚¹1 lakh will fall a lot over these many decades.

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

Rule of 72

We use the rule of 72 to estimate the effect of inflation quickly. 7% inflation of goods and services shows that the cost will double in 10 years, approximately or the purchasing power of money will be cut by half over this period. Using the same examples above,

  • an insurance policy or annuity plan that pays ā‚¹10,000/month, 20 years from now, is just paying ā‚¹5,000/month in todayā€™s money. That will drop further as time passes
  • The same lifestyle that costs ā‚¹ 1 lakh/month today will cost ā‚¹ 2 lakhs in 10 years, 4 in 20 and 8 lakhs in 30 years. The retirement corpus will have to support that level of withdrawals
  • The IIT degree that costs ā‚¹ ten lakhs today will, at 10% inflation, cost ā‚¹ 10 * 1.1^15 = ā‚¹ 42 lakhs in 15 years

We cover the importance of planning for inflation in these posts:

It is important to understand under which circumstances different asset classes handle inflation:

Step 3: Focus on income and human capital

Growing wealth depends on both income and investments and is one of the axioms of personal finance. There is an intrinsic limit to the amount of time you can spend per day or week in your primary profession. If you know your hourly wage, and you should like this, you should also be aware that you cannot scale the denominator i.e. hours/day indefinitely. This leads to the concept of increasing human capital, where you are enhancing your skills and knowledge to increase your income - both active income from your profession and passive income from other sources.

Greatest returns come from human capital

Here we see two investors getting the same average return from their investments over 30 years. One of them gets salary hikes of 10% a year while the other gets 20% hikes. Over time, their portfolios diverge, and the second portfolio ends at a value that is 4x higher than the first.

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

Step 4: Stay liquid and donā€™t be asset rich, cash poor

Being wealthy means that you have money to spend when you need it. If you have a lot of assets tied up in real estate or jewellery having poor returns, that will impact your goals. If you have earmarked a plot of land for your childā€™s education/marriage, will you be able to sell it at the desired price when the money is needed?

Similarly, if you are retiring with multiple rental properties, see if the yield vs the effort it takes to maintain the properties and get tenants are working out for you. If the effort is fine at the age of 60, will it still be fine at the age of 75 or when only one spouse is there to manage the properties? Can a simplified portfolio which is managed by a competent advisor or family member, be more desirable?

Another good example is a heavy allocation to locked in assets like provident fund (EPF, PPF), Sukanya Samriddhi, insurance policies with investment components and NPS. Both EPF and NPS are locked until retirement with extremely onerous exit clauses. If you have a considerable amount of assets in such investments, and face a liquidity crunch like a job loss or medical emergency, getting hold of required funds can become problematic. Some of these assets, like provident fund and insurance policies, allow loans to be taken against them, to partially offset the liquidity constraint. Except NPS investments with a high allocation to equity, all of these schemes are primarily debt schemes and will impact the asset allocation of the portfolio.

Step 5: Manage your risk

Whenever an investor is looking for an investment option, risk must be a serious consideration at that point. Often, when we think that we can take a moderate amount of risk, or high risk, or no risk at all, it points to our risk-taking willingness. Willingness is a subjective metric that deals with behavioural aspects driven by the level of knowledge about personal finance and experience in capital markets.

How the investor actually reacts in situations like the March 2020 COVID crash, or the 2008 Global Financial Crisis cannot be predicted in advance. Therefore, it is essential to know both the risk implied in the type of investment being considered and the investorā€™s own risk profile.

A few risky behaviours that many investors have are:

  • chasing yield in the debt part of the portfolio. Some examples of risky behaviour are investing in NCDs, company bonds, covered bonds and P2P lending to get higher than FD returns
  • believing that more risk implies more return. The opposite is actually true - higher returns generally come due to higher risks being taken. Higher risk just increases the chances of both higher and lower returns. Some examples of this behaviour are increasing allocation to riskier stocks like small caps believing it will definitely increase returns
  • incorrect asset allocation. Asset allocation balances risk from various asset classes to ensure everything asset in the portfolio does not go down (or up) at the same time. Too aggressive (like 100% equity) or conservative (like 100% debt) allocations will lead to the goal not being met.

Therefore, investors should perform a risk profiling before investing using a tool like this: Do not invest in mutual funds before doing this.

Step 6: Remember that you cannot take a loan for retirement

A common requirement of new investors is: ā€œI need to invest ā‚¹ 10,000/month for ten years. The purpose is to grow wealthā€. Readers of this blog will understand that the immediate question that would follow is: ā€œGrow wealth to do what?ā€ and ā€œIs that all that you are investing for?ā€. Both of these questions are answered here:

The related question is, ā€œIs your retirement covered?ā€. This question comes because

  • retirement has to come from your own portfolio and accumulated assets. You cannot take a loan to live in retirement
  • retirement planning is a complicated process. You need to start as soon as possible: What is the danger of starting investments late?
  • the amount of investments, as a percentage of your income, is substantial just to maintain your current lifestyle. If you are creating wealth, would you wish to settle for a lower quality of life when you are not earning? This post discusses this concept in more detail: What percentage of my salary should go towards retirement?

Here lies an essential concept of prioritization. Your monthly income is finite, but your goals and aspirations are not. You also need to balance spending money today vs investing for the future. The concept of prioritization is handled in these posts:

Step 7: Donā€™t forget taxes

No one likes paying taxes. However, just like death, it is an inevitable part of life. When building and preserving wealth, planning for taxes is extremely important. Some investments are highly tax efficient (like capital gains), while others like interest, coupons, annuity payments, and dividends are taxed at the highest slab rate. You should not also assume that

  • the current tax structure related to investments and capital gains will continue in the future
  • your tax bracket will be lower than the current one in retirement. That will generally imply that your lifestyle is at a lower level than the present

These posts cover tax-related considerations when planning investments

Step 8: Use the wealth ladder to guide your behaviour

The wealth ladder applies geometric progression, human behaviour and life goals in one easy to understand construct. If you follow the rules of the wealth ladder, you can climb the rungs quickly.

Level Wealth Can / Should Buy Stretch / Loan Decision-making level
Level 1 10,000 or less Insurance (monthly premium) Emergency fund ā‚¹ 100
Level 2 1 lakh Emergency fund Groceries, Restaurant of choice, White goods ā‚¹ 1,000
Level 3 10 lakhs Groceries, Restaurant of choice, White goods Car, Foreign Vacations ā‚¹ 10,000
Level 4 1 crore Car, Foreign Vacations House ā‚¹ 1 lakh
Level 5 10 crores+ House Luxuries ā‚¹ 10 lakhs

How to understand this?

  • ā€œLevelā€ describes the current rung of the ladder in terms of accumulated wealth and what you can and cannot do
  • ā€œWealthā€ describes the current net worth, and this increases geometrically by 10 times to reach the next level
  • ā€œCan / Should Buyā€ describes what you can do without stretching yourself or taking a loan
  • ā€œStretch / Loanā€ describes what you either should not do or need to take a loan for. The more loans are taken for spending on items belonging to the higher levels, the longer it will take to move to that level
  • ā€œDecision-making levelā€ describes the money threshold that drives your decision making when distinguishing between two similarly priced product/service. We have set this to 1% of the level of wealth

Read more here: How to climb the wealth ladder in India?

Step 9: Start building wealth via goal-based investing

Goal-based investments

For someone who wants to get started, the next step is learning about and following goal-based investing. This process will take considerable time and effort but the result will be worth it: I have just started earning and do not know a lot of finance. What now?

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Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself
OR
use this quick and fast online calculator to find out the SIP amount and asset allocation for your goals.

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This post titled Do you want to create wealth? This is how you should proceed step by step first appeared on 22 Jan 2022 at https://arthgyaan.com


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