Financial Literacy: Or a Guide to Escape “Millennial-style Poverty”

Buzzfeed did what they are good at and used some random anecdotes and created click-baiting content around millennials and “urban poverty” that has generated lot of outrage. This post is not yet another sarcastic take on that. If you set aside the extreme examples used by Buzzfeed and just look around, you will find that financial literacy is a rare commodity. The outrage against Buzzfeed for simply pointing this out seems a bit rich.

I am no less guilty. It was not until I was almost 30 that I probably looked at this as a serious thing in my life. Putting your money to work is powerful. It can help you retire early, sleep peacefully, resist financial shocks, create jobs and even change society. Raghuram Rajan spoke recently about money and what it enables:

“In a free market, all it takes to buy what you want is money. You do not need a pedigree, a great family history, the right table manners, or the right fashionable clothing or looks… It is because money has no odour, because it is the great equaliser, that so many people across history have been able to acquire resources and invested them to make the world we live in.”

Many of the top jobs in the world are all related to efficient capital allocation. Warren Buffet and Charlie Munger at Berkshire Hathaway are a prime example. Google co-founders’ new structure with Alphabet/Google is to enable them to allocate capital more effectively. Cyrus Mistry with the Tata Group has top Managers for every group company while his main focus is strategy and capital allocation. Actually every CEO/Board is supposed to have this as a primary task. If they cannot do better than their shareholders in managing capital then it is in the shareholders’ interest that the company pay dividends with all their profits.

So companies invest in new projects or products in search of wealth creation and financial security. Are these not the same primary reasons why individuals work their whole life? So take charge and be the CEO of your finances. The first step is getting your finances from the red to the black. So you must save.

How much should you save?

It depends on one’s earnings on one side and goals, responsibilities, lifestyle etc. on the other. Do you want to do an MBA? Raise a family? Couple of holidays a year? Build a corpus for a startup? Repay loans? Make a list! Build a career that helps you grow earnings over time. Have a lifestyle that doesn’t break your bank account while indulging yourself.

Improving your lifestyle with increasing salary is fine but try to expand your margin (percentage of savings) while doing so. Don’t grow costs as fast as income. When calculating costs include large one-time expenses like a phone, furniture, a car or a wedding.

Consider this. Let us say your income grows at 10% a year but costs at 5% with an initial savings %age of only 12% of income. You will find that annual income doubles in 8.5 years; costs only in 15 years and absolute savings double in 3 years! I know this seems unrealistic but even a 1% difference in the growth rates gives your long term savings a good boost due to the compounding effect. Conversely, if costs grow faster than income even slightly then you will be bankrupt in a few years. Work out the numbers. In the below charts, the axis on the left represents income and expenses and the other axis shows the %age of savings.

Psychologically, saving is basically about discipline. Build it.

Is it enough just to save? 

The simple answer is no. Money loses value with time. Even if you don’t lock it up in your safe at home, savings typically lie around in savings accounts or fixed term deposits that pay you some interest. This interest rate even if it seems high does not beat inflation (or not significantly enough). Raghuram Rajan explained this with his dosanomics but anyone who buys milk or eats at restaurants would know this. In a low inflation environment it is possible to squeeze out a bit more from these avenues but inflation is a cyclical beast. You cannot trust Governments to have policies that control inflation very effectively.

The second beast you need to fight is taxation. Let us say you saved 100,000 rupees and invested somewhere and earned 10% (10,000 rupees) on it. Depending on the type of investment you may have to pay taxes on the interest earned. This reduces your effective return to 7% if you are in the highest tax slab!

So your tax-adjusted return has to beat inflation over the long run if you want to create wealth.

How do you do this? 

Invest. In India, for all our faults we have fairly well-regulated banking and financial markets. Yes, there are crony capitalists who run down banks and corrupt promoters who loot companies but we are still better off in this regard than even China where bad debts are mounting and the stock and real estate markets have reached crazy bubble situations. If you don’t know enough about stocks then invest in a simple diversified mutual fund. Mutual funds invest in both stocks as well as bonds. In my opinion corporate bonds are no more safer than the stocks so you might as well stick to equity.

Most people cannot pick stocks that beat the market in the long run? Why? Because the market is simply the superset of all people and random factors play a significant role. There are bound to be a number of people who do worse than the market. Also, investment returns are highly variable because of the huge differences in risk appetite and staying power between investors. Even fund managers are not immune to this. You are also not immune to this. So if you don’t know how to do this, stick to equity mutual funds.

To learn more about investing directly in stocks, read up. Building skills like the ability to understand balance sheets, income statements, cash flow accounts and annual reports all come in handy. Every public company is supposed to publish these on their website. But there are some services that compile and share details that you need: Screener and Craytheon (subscription required) are examples of financial data providers in India. There are equity research reports you can get your hands on here: Morning Star India (login required). If you want to know about all the pitfalls of stock and bond markets, read the age-old book by Benjamin Graham, The Intelligent Investor. The author is Warren Buffet’s guru and started teaching investing right around the time of the Great Depression.

But aren’t stocks risky? 

Psychologically, investing in stocks is about patience and keeping faith in your judgment even if there is panic around you. Have you heard about the relative who bought a stock after he saw in the news that it grew by 40% and then saw it tank? Have you heard about a friend who panicked and sold shares at a 20% loss because the markets were in a seemingly bottomless downtrend? Let us borrow the Mr. Market allegory that Benjamin Graham created and show why this is poor judgement.

Mr. Market comes to you every day at a fixed time and either offers to sell you a kilo of onions or buy the same from you. He sets the offer price each day but you have the freedom to accept or reject the transaction. Let us assume that the supply and quality of onions are steady and that over the last year the cost of growing and transporting onions to markets was 20 rupees a kilo and you know all this. If he comes to you and offers to sell onions at 40 rupees today, will you buy it? What about at 10 rupees? What if he offers to buy your onions at 10? Will you sell them? What about at 50 rupees? The decisions seem quite obvious! Assuming the quality is the same, you buy when prices are low and sell when they are high.

Yet, in the stock markets the behaviour is completely opposite. Note that companies declare results only every 3 months. Minor news does come up every now and then but that doesn’t justify the daily price changes of the markets. The markets are volatile (different from risky!) because of various factors like staying power and leverage of the participants.

In the onion example, what if you had borrowed money and purchased onions at 20 rupees. You have to return the loan in 2 days. Mr. Market was offering 25 a week ago, 19 yesterday and only 17 today. Will you sell now or wait? Don’t borrow to invest! That way you can improve staying power. You should be the one who buys the onions at 17 rupees from this guy who is forced to sell!

The other factor that influences staying power is using the stock market to make a quick buck in a short time for an upcoming expense. If you need to pay the down-payment on a house in 6 months, don’t invest your currently saved corpus in stocks. When the market falls, you will sell at a loss.

All this assumes that fundamentally the stock is good, so do your analysis. As opposed to market volatility,  risk comes from the fundamentals of the business and industry of the company. Stocks don’t offer a guaranteed return and any business has its risks. Diversifying is one option to mitigate against risk if you don’t get too much time to do research. But studying companies and the market conditions well is a better option based on my personal experience.

The key questions are: Is this business doing well? Is it available for less than what it is worth? Is the management team qualified and ethical? What is their track record? Do they have loans under control? How are they doing when compared to competition? Yes, it’s a lot of work. You will have to sacrifice a couple of weekends every now and then to do this right! If you cannot do this, then invest in mutual funds.

Buying more without panicking when the markets are down lowers your acquisition costs and can boost future returns. You can take advantage of volatility while being cognizant of business performance and challenges. If you invest 10,000 rupees a month when the stock trades at 100 you get 100 shares. When the stock trades at 50 you get 200 shares for the same amount. Your average cost is not 75 but 67! When the price gets back to 100 you make a cool 50% return.

So market irrationality can increase a sensible person’s returns!

The best market for someone who is going to invest every month for a long time is actually a prolonged slump when stocks are cheap and an eventual rise. But stocks are cyclical beasts just like inflation. Disciplined regular investing still beats trying to guess when the market will be low.

I said earlier that fund managers are not immune to irrational behaviour. Why? If you can enter and exit funds at any time and a fund is composed of irrational investors then people redeem when markets fall and buy when it is high. The fund manager has no option but to follow this inflow and outflow of money. Exit loads are used to control this behaviour but I doubt they are effective. Funds are still better than speculation or bank deposits. Some funds also control entry/exit with some rules.

The other reason why stocks make sense is that we don’t have any taxes on long-term capital gains on stocks in India (at least for now). Plus “long-term” for stocks is just 1 year compared to real estate which is 3 years.

What about real estate?

Buy a house if you want the psychological comfort of your own home or to retire in when you are not earning any more. But remember that it may not be good enough as a pure investment. Everyone knows people who multiplied their money in real estate. But it is not for everyone. Property titles and guarding them is a risk. Luck and location play a large role. Built-up property depreciates no different than a car some times. Plus if you move for work you need to manage tenants remotely.

Home loans to buy property makes it an even more doubtful investment as the tax-adjusted return needs to now beat your tax-adjusted loan interest. Transaction costs are high especially if you need brokers to manage it.

Long-term capital gains taxes are also applicable beyond 3 years. A lot of real estate transactions also happen in black in India to avoid registration fees and taxes or simply to hide ill-gotten money. So be careful!

What about trading?

My belief is that you should not speculate unless you can afford to gamble. Every day-trader boasts in public only about the wins. No one wants to admit how they washed all their money down the toilet betting daily in the markets. Plus there are some trading strategies (using certain types of futures and options) that have limited upside consistently which look like regular income but unlimited downside when rare events happen that can wipe out a whole lifetime of upsides. Be doubly careful!

When an online broker offers you a loan to trade, be very skeptical! If money could be made by trading this way, they would be trading with their money and not lending it to you. You would be better off investing your savings and spending your work day building your career thereby increasing your future savings!

If you made great money while trading, congratulations! You don’t know how lucky you are. The rest of us need to find other ways.

What if markets fall and fall hard like the recent recession? 

If you have staying power of a few years and don’t need the money immediately you can weather the storm. You can do this if you have protected yourself against shocks (see below) especially if you haven’t got fired. If you still have your job, you can buy stocks at a hugely cheaper rate to lower your costs and gain when the rise happens. You can also sell when markets are irrationally high because usually this means a hard landing is coming up. Markets usually bubble up when there is cheap credit in the market. Why would someone pay 40 rupees for something worth 20 rupees? May be because they saw it rising and were offered a loan to participate in the boom. When this free money dries up there is a hard landing as there is a race to sell and recoup money. So normally hard landings are preceded by booms.

In the onion example, you can sell your entire stock when you are being offered 40 for something that is worth 20. You do this either because you want to book gains (if your job security is low) or don’t have staying power when the hard landing comes. If not, stay put!

What about my own business?

Sure. If you are passionate and know your stuff, go for it. You are the job creators Rajan spoke about!

Think of it as investing in your one single company instead of investing in many others. I don’t have any personal experience here so I wouldn’t claim to know anything about this. From what I have seen and heard though, keep tight financial control and monitor your company performance the same way you would judge a stock you are evaluating. Don’t rely on your accountant to understand your company’s performance and money-making (or burn-rate!) model. Build adequate protection against personal financial shocks.

How do you deal with unpredictable financial shocks?

Keep some liquid cash in savings or deposit accounts. “How much?” depends on your needs. If you are an employable bachelor who has no dependents may be a couple of months salary might do. With a family you might need more. With loans, even more.

Also if you have a large expense coming in a few months (say a wedding), it is probably not a good idea to park money in stocks to pay for this because your staying power is low if the market drops. Try to plan well in advance (18 months or more) or alternately park the money in more liquid assets with guaranteed returns.

Get insured! Insurance is a way of protecting you and your family from shocks that you cannot afford. Get life insurance and disability benefits to more than cover your loans and the needs of your dependents. Get medical insurance for dependents or work at a company that covers this. Insurance is cheaper earlier in life. So do this sooner rather than later.

Insurance is not like another expense. It is basically downside protection for your investments against an improbable negative event. If you need 1,000,000 rupees for a medical emergency, it can wipe out several years worth of savings.

Insurance is not an investment either! ULIPs and other fancy products neither give you enough insurance coverage nor enough investment returns. Also insurance companies are not necessarily good money managers. Buy term insurance so that you pay only for the risk and not to inflate the insurers bottom-line.

Can it all still fall apart financially?

Statistically in a planet of 7 billion people, there are going to be some who did everything right and then got screwed anyway. So invest in yourself and your family: health, skills and relationships. A gym subscription, learning how to code or cook, teaching life skills to your kids early are all intangible investments that can be invaluable during hard times. A come-back will be made.