MUMBAI: The mood on Dalal Street seems cautious at the start of the New Year after a sizzling run in the stock market in 2014. With the pace of implementing pro-market measures by the government turning out to be far slower than what investors expected and concern over a likely slowdown in foreign portfolio inflows heightening, investors are bracing for moderate returns from the stock market in 2015. 

Money will come and go; after all, you just have a life to live –why not live it to the fullest? Sounds perfect and positive, isn’t it? Unfortunately, if you are living your life like that, not everything is positive and perfect. You will realize the perils of reckless spending when you face a financial emergency. I have done it in my initial investing life– reckless spending – but soon realized that you cannot discount uncertainties in life. A sudden drop in my monthly cash flows turned my life into a nightmare. So, when i write my sixth principle, I have my own experiences to back it up!
The principle is not very hard to follow – never take money from your savings or borrow temporarily from your friend’s pocket to buy a little more luxury. Be it a slightly bigger house that caught your wife’s imagination or the latest electronic gadgets.
WHERE IS THE PROBLEM?
The lifestyle you want to maintain depends on three factors:

• The circumstances in which you were born and bought up
• The kind of friends you have
• The place or community where you live.

Have you asked your parents about how they started their life? They din’t have a big car or latest electronic gadgets. They probably didn’t live in the big apartment or villa they’re living right now. They built everything brick by brick. It would have taken a lot of time, effort and disciplined life to get to where they are now. That’s exactly the way you should also start off. If you try to achieve all the life’s goodies in very short time, there’s every possibility that you’ll borrow a lot of money assuming that you’ve the ability to re-pay everything in 5 or 10 years and chances are that you’ll get into debt trap should there be an unexpected fall in your monthly income.
Another problem amoung youngsters is that spending habits are greatly influenced by their friends and colleagues. Bank balance doesn’t matter, the car or home doesn’t matter – what matters is the answer ‘yes’ to this question- Are you better off than your neighbor , friend , relative or colleague? If the answer is yes, you are confident, you feel happy. Or else – you stretch beyond your limits to maintain yourself the standard of living that your friend has! You will over borrow, over spend or do something to satisfy your ego. This category of people falls into the trap of personal loan providers. Personal loans are easy to get. There is less documentation and there are no restrictions on how you use the money. Since money comes in quickly with minimum documentation, you won’t mind the higher rate of interest.
Another reason for reckless spending is that these days, a lot of technologically advanced gadgets and appliances are introduced into the market that drives everyone crazy. Financial schemes are introduced by institutions which would seem like a very simple deal. These schemes are advertised in such a way as to lure customers. Such facilities tempt us to spend more. When you buy into such schemes, what you are actually doing is getting into the finance trap. I am sure 99% of people reading this would have done this in some form or other.

That’s principle 6 for you. It’s always wise to stay within your limits.
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Cash reserves are money kept aside as an emergency fund. We are discussing the need to keep cash reserves as our fifth principle because, this is one important idea which most of us neglect. When you set aside some money from your earnings to meet unexpected expenses, there are four advantages that automatically comes with it:
1. Financial safety.
2. It allows you to take advantage of a surprise financial opportunity
3. It creates a compulsory saving habit.
4. Since funds are kept in liquid cash or gold, it earns interest or appreciates in value.
We recommend to create an emergency fund that equals to 4 or 5 months of living expenses; however, you do not need to set aside this total amount in cash alone. It can be in short term fixed deposit or Gold etc..
HOW MUCH RESERVE?
That depends from person to person.
There are a number of factors that influences your decision on the quantum of emergency fund that needs to be created. Factors such as age, occupation, health condition, monthly EMIs, number of members in the family, other sources of income needs to be considered on a one to one basis.
1. AGE:
Depending upon how old you are, the emergency fund required keeps changing. As you grow older, the possibility of medical emergencies is also high. Hence, if your age is on the higher side (let’s say you’re 45 years old) you also need an emergency fund that’s higher than some one who is just turning 30.
2. OCCUPATION:
The style of occupation/business you do is another factor that influences emergency fund decisions. If you are doing a seasonal business or if your job has an uncertain future, you need a higher emergency fund. People living on commission based income would also require a high emergency fund.
3. HEALTH CONDITION:
More reserve funds may be required for a person whose health condition is questionable. The amount of insurance cover he has should also be considered while assessing his future requirement. Higher the insurance, lesser the need for reserve funds on these grounds. Again, if you have your parents or grand parents living with you, you might need to plan accordingly.
4. MONTHLY EMIs.
The volume of debt you have needs to be analysed to get an idea about how much EMIs you’ll have to pay a month. Typically, while creating reserve funds, an amount equal to 6 months EMIs should be kept aside so that in case of emergency, you don’t default in your loan payments. A clear track record of loan re-payments is absolutely necessary for your future financial needs.
5. NUMBER OF MEMBERS IN FAMILY.
If the numbers of members you need to support are more (say 7 members) naturally you need a higher reserve than what would be required if you have only say, 3 members in your family.
6. OTHER SOURCES OF INCOME
You can count on your other sources of income, if any, while creating a reserve fund. One time or casual income or credit card limits should not be considered in this group. However, you can count on the income of your spouse or other family members staying with you in case of emergency.
7. OTHER POSSIBLE EXPENSES.
You may also want to consider other expenses like possible higher education fees for your child who is about to enter college or a possible repair for your house. It all depends from person to person.
HOW TO KEEP RESERVE FUNDS?
Hundred percent of your reserve funds need not be kept in liquid cash. A portion of it can be kept in short term fixed deposits or debt funds and a certain portion in gold or easily marketable securities.
Any cash lying idle over and above your emergency fund results in a lost investment opportunity. You are not making your money work efficiently for you.
THUMB RULE
The thumb rule is – You should have enough reserves to meet all the expenses for 4 or 5 months plus some extra to meet unforeseen expenditure like medical expenses.

HOW TO SPOT IDLE FUNDS?

• First estimate how much emergency fund you’ll require. (typically 3-6 months expenses)
• Now see how much you have in your bank account plus cash in hand.
• Deduct 3 or 6 months emergency fund. The balance is your idle fund.
• This fund should be invested immediately. You can take up a systematic investment plan so that an amount gets invested automatically every month; or you can open an online trading account and invest in stocks or mutual funds at your convenience ; you can opt to open FD linked savings account so that any balance above a certain limit automatically earns interest at a higher rate and so on..

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INTEREST
Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.Its also the compensation you can demand if someone delays a payment that’s due to you. If you think clearly, the two concepts we discussed earlier viz, time value of money and compounding were based on the concept of interest rates.In this post we are discussing certain practical scenarios where interest rates can baffle you. It’s discussed under two heads
1. Interest payments
2. Interest incomes.
INTEREST ON LOANS
Interest rates are always tricky.  In most of the cases, interest rates advertised by the banks are not the actual rate of interest you pay. It’s something more than that.
Trap 1.
When you apply for a loan, there are a lot of financial charges you need to consider before deciding whether to avail it or not. For example – you are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high.
Is that all? No. The bank will also deduct a processing fee of 1 % of the ‘total amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.
Trap 2.
You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But look closer – reducing balance can be on monthly basis, half yearly basis or on Annual basis. If it’s on annual basis – your interest is calculated on the amount outstanding at the ‘beginning’ of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay.So always confirm whether the reducing balance is on annual basis or half yearly basis.
Trap3.
Higher loan pre-closure charges. The bank would like you to pay your EMI’s regularly. If you do that, the bank likes you so much that on the basis of that regular loan track, they will sanction a second loan if you want. But – if you try to close off your loan liability before the stipulated loan period – the bank will charge an additional amount of 3% to 4% on the outstanding principal. They don’t want their customers to be ‘Too regular’. strange isn’t it?. That’s the way bank deals with it’s customers. If you try to be too good , you’ll be fined This preclosure charge you pay effectively raises the cost of your loan.
The solution-
The best way to deal with these traps is to stop comparing the interest rates and instead, compare the EMI’s and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you.
INTEREST INCOME
The principle to be applied is quite simple – The earlier you get it, the better it is.
This principle will help you to compare different offers. For example – A bank offers 8% P.a  interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a – payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% !
How? Let’s calculate with an example –

• Let’s assume that you have 2 lakhs with you.
• The first bank would give you 8% – annually so, you receive an interest income of Rs.16,000 at the end of one year.
• Suppose you depoited the same with NSCThey would give you  8% -half yearly. So, at the end of 6 months you get Rs 8,000 which can be again invested for 8% interest for 6 months whch gives you an additional interest of Rs. 340. So, the total interest you receive is now Rs 16,340. effective rate – 8.16%
• Similarly , when you work out 8% interest received on a monthly basis the effective interest rate would workout to 8.30%
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  Financial Discipline for all:: Principle 1.Finding money
  Financial Discipline for all :: Principle 2.Time value of money
  Financial Discipline for all : Principle 3. Compounding

   
   
   

When asked to name the greatest mathematical discovery, Albert Einstein, one of the most influential and best known scientist and intellectual of all time replied – “compound interest”.

Let’s try to understand why he said so with a very simple example:

• Jerry starts saving when he turned 25 and invests Rs 50,000 every year. He earns a return of 10% every year.At the end of ten years; he has been able to accumulate Rs 8.77 lakh. After that, he dosen’t invest Rs 50,000 anymore. He leaves that investment there until he’s retires at 60. At that time,  he would have accumulated around Rs 95 lakhs .
• Tom, had fun and lived his first few years spending on all kinds of things and did not think of investing regularly. At 35, he starts to invest Rs 50,000 regularly every year until he retires at 60. I.e. for 25 years. But, he would have managed to accumulate only Rs 54.1 lakhs which is around Rs 41 lakhs less in comparison to Jerry.

5 simple points spell out from this story:

• Even by investing two-and-a-half times more than Jerry,Tom has managed to build a corpus which is 43% less!
• Why? Because,Jerry’s Rs 5 lakhs was allowed to compound for a longer period of time than Tom’s.
• As the fund grows, the impact of compounding is greater.Jerry starts at 25, accumulates 50,000 for ten years, stops at 35 and then, his 8.77 lakhs (5 lakhs + Interest) is allowed to compound for 25 years till he’s 60. Whereas Tom starts at 35 and invests Rs 50,000 for the next 25 years, accumulates 12.5 lakhs (50,000 x 25) only to get 54.1 lakhs at 60.
• Now let’s assume that Jerry had allowed the fund to compound for only 20 years i.e.  Till he turned 55. At 10% return every year, he would have accumulated an amount of around Rs 59 lakhs. By choosing to let his investment run for 5 more years, he accumulates Rs 45 lakh more.
• Essentially, compounding is the idea that you can make money on the money you’ve already earned.

Compounding is very powerful.As Napoleon hill has said- “make your money work hard for you, and you will not have to work so hard for it” To take advantage of it, you have to start investing as early as possible.The earlier you start, the better it gets.
Easily said ! isn’t it?
I know it generally doesn’t work as i said. Because at 25, most of you haven’t drawn a plan to invest 50,000 a year. Even if you’ve done it , somewhere down the way , you’ve missed to add to your corpus regularly year after year. And , due to some emergency that crept in, you took back some amount from the corpus and din’t let your money grow !
So , how can a regular person use it to his/her advantage? Always remember to reinvest interest or dividends received on your investments. Over a period of time, such small amounts will add up to a tidy sum.
FREQUENCY FACTOR IN COMPOUNDING
The frequency of compounding is a major factor that that influences the compounding effect. The shorter the compounding frequency, the earlier your interest is re-invested and thus you earn more interest and your money grows faster.
Here’s more examples:

• Savings of Rs 2500/- per month (Rs.30000 Per year) with 15% return will be worth Rs. 15028707/- (1.5 Crores) after 30 years. Yes, this is not typing error. It will be worth Really 1.5 Crores.
• Savings of Rs 2500/- per month (Rs.30000 per Year) with 15% return will be worth Rs. 30400370/- (3.04 Crore) after 35 years.

COMPARATIVE CHART.
Here is a comparative chart for you to understand.
Let’s assume that you invest Rs 10,000 annually. Your retirement age is 60. Let’s also assume that the interest rate you get is 10%.
At the age of 60 you will have -

• 49 lakhs -if you had started investing from age 20.
• 30 lakhs -if you had started investing from age 25.
• 18 lakhs – if you had started investing from age 30.
• 11 lakhs – if you had started investing from age 35.
• Just 6 lakhs – If you start at 40!! Take note of the impact.

Oh! That’s a huge difference! Now that you realized it late, what can you do? You can start now, invest more and reach the target of 49 lakh at age 60. This would mean more hard work and budgeting for you.   Let us see how much more you would need.
To get 49 lakhs at age 60 –

• Invest 10,000 annually – at age 20
• Invest 16,500 annually – at age 25
• Invest 27000 annually – at age 30
• Invest 45,000 annually- at age 35
• Invest 78,000 annually – at age 40!!

Generally what I find is that most of the Indians start thinking of saving and investing at the age of 30-35. The above calculation is made assuming that the interest rate you get is 10 percent. But the average interest rate of banks is less than that. I hope the picture is now clear for you. The more you delay, the more you need to invest.

Hope you have understood the concept of compounding and how it impacts your savings. That’s principle 3 for you.
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