“Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give.” William A. Ward
I would like to start with good news – the second edition of my first book, ‘Musings of a Financially Illiterate Father’, which is an Amazon bestseller, has been rated number 2 amongst the top books of 2020, by its publishers, Natraj Publishers. It has been possible due to your support and love and I pray for your continued indulgence. I will request you to please share this book with your friends and family for them to benefit from it.
The first part of this series, based on the iconic book, ‘The Millionaire Next Door’, was received very well by you. I hope you remember the three lessons that we learnt last week as we build upon those in this concluding part. In the quest to our wealth-building, one of the most tantalising questions we face is – “Are we on track towards wealth creation?” If we don’t know the answer to this important question, we may slowly drift away from our ultimate goal – to retire rich, a time when our regular income stream would have dried down. This book provides a rough-and-ready method to calculate whether you are on the correct track to be wealthy. Let’s dive into the formula with this lesson number 4.
The Road to Riches: How Wealthy Should You Be?
Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be
Let’s demystify this yardstick with an example. Suppose you are 40 years old with an annual gross income of Rs 12 lakh. Your net worth should then be Rs 48 lakh (40 *Rs 12 lakh/10). Of course, this is the ‘Ideal Net Worth’ one should have but life is never utopian and in actual one’s net worth will be more (less likely) or less (more likely) than this ideal figure. The net worth is incidentally a total of all your assets less the liabilities. The authors have further given a few practical yardsticks to slot oneself appropriately on this ‘Wealth Scale.’ They have also introduced a few important terms.
- Prodigious Accumulator of Wealth (PAW): If your net worth is twice or more than the level expected as per the above equation.
- Under Accumulator of Wealth (UAW): If your net worth is half or less than the level expected as per the above equation.
- Average Accumulator of Wealth (AAW): Anyone in between UAW and PAW.
Getting back to our ongoing example, if one’s net worth is Rs 96 lakh or more, he is a PAW. If it is Rs 24 lakh or less, one is a UAW. Anyone in between these two figures will be an AAW- of course the one closer to Rs 96 lakh will be a happy AAW while the one closer to Rs 24 lakh – well you decide for yourself.
I will urge you to calculate your net worth on an excel sheet and then keep track of it every quarter. It should keep increasing. If it is not so, please take steps that I have been enumerating in my musings to nudge it in a positive direction. This one step alone will instil fiscal discipline in your life leading to abundance.
Big Hat and No Cattle
A big problem with (Upper) Middle-Class people is their need and aspiration to maintain a lifestyle which clearly their income can’t sustain. They need to wear certain kinds of clothes, live in a certain kind of neighbourhood (where people much better off than them live), dine-in certain kinds of restaurants, drive certain kinds of cars and go to certain (or costlier) holiday destinations. The list is endless. I’ll recommend that you to watch the delightful movie, ‘Hindi Medium’ starring Irrfan Khan, to experience this point in action.
When we compare a lower-middle-class person’s lifestyle to the one described above, we find that they don’t have pressure to ‘show off’ and hence are content with a lifestyle which generally is bereft of the ‘rich trappings’. So, they can still use a two-wheeler, go for vacations to ‘Nainital’ (I am not disparaging this beautiful place which is one of my favourite holiday destinations) and buy vegetables from the local ‘Sabzi Mandi’. In the bargain, they can actually save/invest much more than their ‘Upper Middle Class’ counterparts. Over time, the magic of compounding (for lower-middle-class persons) and the tyranny of compounding (for Upper-middle-class persons) works, as it should, and we find the financial fortunes of their next generations change for the better/worse.
It is unfortunate that some people judge others by their choice in foods, beverages, suits, watches, motor vehicles, and such. To them, superior people have excellent tastes in consumer goods. But it is easier to purchase products that denote superiority than to be actually superior in economic achievement
Of course, what I am postulating is not a universal truth and there are fiscally prudent upper-middle-class persons and extravagant lower-middle-class persons. But overall, the need/desire of resources to maintain a ‘rich’ lifestyle is bound to be more with an upper-middle-class person.
Perhaps you aren’t as wealthy as you should be because you traded much of your current and future income just for the privilege of living in a home in a high-status neighbourhood
If we combine this point with the previous one (net worth), we come to the obvious conclusion – that one’s wealth doesn’t directly depend on one’s income. So, a lower-middle-class frugal person may be an AAW while an upper-middle-class ostentatious person may be a UAW. Frugality in life remains the key to long term wealth accumulation, but being frugal is not being miserly. The dictionary meaning of frugal is, “behaviour characterized by or reflecting economy in the use of resources” meaning that the person is not wasteful, ostentatious and a spendthrift.
This simple truth often eludes many of us. All we need to do is to ensure that we are strictly living within our means and not on credit where we spend tomorrow’s income today (credit cards are an apt example). I will exhort you to read my post on spending- investing (SI) balance where this issue has been deliberated upon in detail.
Do not spend tomorrow’s income today. This will keep you off the earn-and- consume treadmill
Habit is the Key
Sow a thought, and you reap an act; Sow an act, and you reap a habit; Sow a habit, and you reap a character; Sow a character, and you reap a destiny
I am very fond of my morning jogs/walks which are almost religious to me, the most cathartic activity in the day that I undertake. As I see the people who are on the road/gym every day I can’t help but think – they look fit, why do they need to run/walk. Of course, the answer is pretty obvious; they are fit because they are in a habit of morning runs/walk. The same is true with the wealthy people – when one sees their frugality; one knows the foundation of that wealth.
The SI Balance will give you the discipline in life to get your financial priorities right. Do follow it scrupulously for long term ‘financial habit-forming’. When you get a pay raise, a bonus, an unexpected windfall – you know what to do with it, right? Invest it, at least 50% of it.
Build Financial Muscle
On average, millionaires spend significantly more hours per month studying and planning their future investment decisions, as well as managing their current investments, than high-income non-millionaires
This point was also highlighted in the book, ‘The Richest Man in Babylon’, on which I have done a series- please revisit it. The ironical truth is that an AAW person, who can afford to take a financial hit, is always very careful about his investment decisions. A UAW on the other hand, despite having little financial capital, will be more careless or reckless with his financial decisions.
The difference between the two is due to their financial education levels. An AAW person keeps acquiring and updating his knowledge while a UAW finds more important topics to invest time in. So, Trump-Biden tiff, NBA matches, Stand-Up comedies, the latest fiction, binge-watching Netflix, and so on, will keep a UAW busy. Gaining financial knowledge will be the last of his/her priority. Don’t get me wrong- it is not my pitch that all the topics I have mentioned above are not worthy of spending time upon. All I am saying is that keep a few minutes dedicated for gaining financial knowledge as well. Do endeavour to increase your Financial Quotient (FQ) and hence your wealth.
Pay Yourself First
I have already covered this concept in detail in my previous posts. I will request you to go through it again, as it remains the fundamental concept for long term wealth generation. American Millionaires (more than half) invest first and then spend. The minimum they invest is 15% of their annual realized income. What does the ‘pay yourself first’ strategy do? It creates an artificial economic environment of scarcity for the household, which in the long term, results in their being Millionaires. Obviously, the money that doesn’t come into your hands is not missed by you, so start paying yourself first.
The Power/Tyranny of Compound Interest
I have covered this concept too in my previous posts. The authors give a wonderful real-life example of the same. The parents of one of the ladies, who was interviewed by the authors, were chain smokers consuming three packs of cigarettes a day which translated to 1,095 packs a year. Over their smoking lifetime of 46 years, they smoked more than 50,000 packs which cost them approximately US $33,000 – more than the purchase price of their home.
The tyranny of compounding starts here. If they had invested this ‘cigarette money’ in an index mutual fund, it would have been worth nearly $1, 00,000, a humongous amount indeed. But what if they had purchased shares of the tobacco company (Philip Morris – which they smoked) from their cigarette money and then reinvested all their dividends received during all of 46 years? Their tobacco portfolio would have been worth $2 million.
This is a classic case of understanding the tyranny/power of compounding, which any smart investor should endeavour to work in his favour to accumulate wealth. The seemingly small expenses – our latte factor (I have written about it too), can grow to serious amounts if invested regularly.
Income Tax – an interesting take
Tax and death are the only two certainties in life – so goes the axiom. The authors give a very interesting take on income tax. We tend to think of income tax in relation to our realized income, but what if we calculate income tax in relation to our net worth? We will suddenly find our true financial status. We have already seen what the net worth is, so let’s see this concept in action.
We take two persons – let’s call them Mr. PAW and Mr. UAW (remember the definitions?), both 40 years of age with an annual income of Rs 20 lakh. Since their annual income is the same, both pay income tax @30% of income i.e., approximately Rs 6 lakh. The net worth of Mr. AAW is Rs 1.6 crore while Mr. UAW is Rs 40 lakh. What is the percentage of tax they pay in relation to their net worth? Mr. UAW pays nearly 15% of his net worth as tax while Mr. PAW pays barely 4%.
See how stark the difference is? This has occurred due to power/tyranny of compounding over time – both have been earning for the last 15 years. While Mr. PAW has been frugal (hence now wealthy,) Mr. UAW has been a spendthrift (hence now fiscally poor).
If your goal is to become financially independent, your plan should be to sacrifice high consumption today for financial independence tomorrow
The authors provide some practical pointers towards purchasing of major assets like house and car. So far as the house is concerned, the total mortgage of the house (if you are not buying it on hard cash) should not be more than twice your household’s total income. Taking our example forward, a person with Rs 20 lakh annual income should not go for more than Rs 40 lakh mortgage – a lovely rule of thumb indeed.
The UAWs have an interesting way of purchasing a car. They first decide on the type and model of the car, which invariably is the latest and the most fancy, and then go for a hard bargain with the dealer(s). Of course, they manage to get some freebies on the car and thus pat themselves on the back for a wonderful deal. What they fail to realise is that they could never afford that particular car, to begin with. A new car loses nearly 25% of its value the moment it is taken out of the showroom. An AAW/PAW, on the other hand, goes for 2-3 years old used car unless he can buy the car cash down – for which he saves methodically. He drives this car till he could i.e., for next 10 year or so and then repeats the above process.
We can ourselves decide what is the price of the pride of owning a swanky new car vis-à-vis one’s eventual net worth. It is difficult to live in a Mercedes or BMW after retirement, no? And just as an aside, Mr. Azim Premji, chairman of Wipro, always buys a 2-3-year-old car. Incidentally, he also travels by the economy class when flying. Do you now know the secret of his being a billionaire?
The Legacy Journey
As per the research of the authors, the UAWs tend to produce children who will eventually turn out to be UAW themselves. This is not surprising since children imbibe the values which they see in their house while growing up. Children of UAW see ostentatious lifestyles, spending without planning, and consumption chasing behaviour of their parents. Little wonder that their DNA is accordingly shaped.
The children of the UAWs try to emulate the lifestyles of their parents which came about after many decades of earning. Once they start earning they want to fast forward to their parent’s current lifestyle while earning one-tenth or thereabouts of their income. Aren’t they doomed for UAWship (sorry for non-standard English!) as their aspirations and lifestyle will not be supported by their current income?
The final and an extremely important point from the research pertains to the investing style of the UAWs/AAWs. Most PAWs/AAWs are passive investors meaning that they don’t dabble in active stock picking. Even if they buy a stock, they tend to hold it for a real long time. The UAWs on the other hand were found to be active stock pickers, buying and selling frequently, incurring costs in the bargain. Also, this behaviour invariably ensured that they bought a stock well after it was selling low and tended to sell it well after its peak price.
The UAWs also tended to rely on their financial advisors blindly including ‘cold callers’- they tended to buy ‘stocks of the week’. On the other hand, the AAWs/PAWs tended to listen to their financial advisors but eventually made their own investment decision, based on their research – since they had built up their “financial IQ” over a period of time.
We have covered a whole lot of issues while going through this wonderful book, uncovering real gems of investing which are from the real lives of American millionaires. It is said that success as also successful people always leave clues. We will do well to emulate the lessons that have been covered in the last two posts – albeit duly tempered with our “financial IQ”.
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