You are richer than you think you are, and you have far more financial resources at your disposal than your bank account balance would suggest. The trick to unlocking those resources lies in understanding the relationship between money and time, and then having the discipline to abide by the rules that govern that relationship.
This article will lay out those fundamental principles to help guide you in your process for developing a personal financial plan and unlocking the full potential of your money.
Here are five simple rules to live by.
- Know what you are saving up for, and how much time you have to save for it
Strange as it may sound, most people cannot list the biggest expenses they expect to have in their lives. In general, however, it is safe to assume that there are five key expenses that most people will need to save for. In order of importance, they are: personal retirement, emergency cash reserves, buying a home, paying for one’s children’s education, and children’s weddings.
Not all of these are expenses that are relevant to everyone’s life, and different people may expect to pay for all or part of each of these expenses, even if they are relevant (for instance, your spouse might pay for half of your children’s expenses, etc.) The key to understanding these, however, is to be up front and honest in communicating about exactly what the expectations are between you and your partner on who pays for what. And it may also involve having some hard decisions to make about exactly what kind of lifestyle you can afford.
You should also try to specify an amount that you plan to spend for each, and a date when you expect to actually have to spend the money. For instance, for the house: when do you want to be able to buy it? Ten years into your career, or 15 years? And do you really want to go after that 1,000-square-yard house in DHA or are you better off with a three-bedroom apartment in a reasonably safe neighbourhood?
Children’s education: to send abroad or within Pakistan? If abroad, where? How fast do educational expenses rise over time? And how much income would you realistically want during your retirement? Do not assume that your expenses will go down. They never do. All of these are data points that one may need to research in order to come up with a viable plan. (Disclosure: I am the founder of Elphinstone, a company that offers personal financial advisory services to consumers in Pakistan.)
- Your money needs to be beat inflation
Leaving your money in your bank account – even if it is a savings account – does not count as investing. Neither does putting your money into a committee. The rate of return on these two investments is 0%, and every year, your money loses value due to inflation. Between 1958 and 2020, inflation in Pakistan has averaged 7.6% per year, so in inflation-adjusted terms, an asset that has a 0% return really has a negative 7.6% return.
So any investment you make has to beat inflation, and ideally it should have returns that beat inflation by as much as possible. One thing to keep in mind, however, is that when you are evaluating assets to invest in, the returns you look at should be long-term return averages, not short-term averages. Any asset class can do very well in a short period of time, but its true test is how well it performs over the long run.
Examples of asset classes that do very poorly relative to inflation – over the long run – in Pakistan: bank accounts (even savings accounts), and any foreign currencies.
Examples of asset classes that have – over a long period – tended to beat inflation in Pakistan? The number one asset class is stocks, followed by real estate, and bonds. Gold also does well, but can be as volatile as stocks with much lower returns (yes, gold is not a ‘stable’ investment) and so we generally advise staying away from the commodity.
- Invest early
Do not think that you can start investing later. The earlier you start, the more time you give your money to compound itself.
Over the past two decades, stocks in Pakistan – as measured by the benchmark KSE 100 index – have yielded, on average, 19.0% per year in total returns for investors who remained invested in stocks starting January 1, 1999 (as of September 1, 2020). During that time, inflation has averaged 7.6% per year, meaning that the inflation-adjusted returns on Pakistani stocks has been 10.6% per year on average.
Those kinds of rates of return mean that there can be a huge difference in the amount a person can save up depending on when they start. For example, let us suppose a 22-year-old person graduates from college, and immediately starts to save for retirement. For every Rs1,000 per month that they start saving at that age, they could have Rs28,669 per month in income (inflation-adjusted) by the time they retire at age 65, assuming they are able to continue earning market rates of return.
Now let us suppose they wait until they are 25 to start saving for that same retirement age of 65. Their expected retirement income would go down to Rs21,071 per month (inflation-adjusted). Just a three-year delay made a 26.5% difference in income!
What if they wait until they are 30 to start saving? Well, that monthly retirement income number goes down to Rs12,561, in inflation-adjusted terms, a decline of 51.4%.
Investing early, in other words, matters a lot. But do not panic if you are older and have not saved early. You can still catch up, but just be aware that the older you start, the more money you need to start putting away to achieve the same retirement income.
- Invest often
While the averages are good to know, it is also important to realise that the markets can be quite volatile and at any given moment in time, your investment may be profitable or in a loss-making position. The important thing is to not sell in a panic, nor to start buying too much when the market is rising fast. Investment plans need to be systematic, and the best plan is to simply put away a certain amount of money every month towards each of your savings goals.
Do not try to time the market, especially in the hunt for unreasonably high returns. To chase unreasonably high returns is, in market parlance, to be a pig. And there is an old market adage about pigs: “Bulls make money, bears make money, but pigs only get slaughtered.”
- Automate your savings
The biggest principle of investing, however, is to know human behaviour, and to know that if saving and investing is something that one needs to do manually every time, it will not get done. The only consistent way to save money is to have it be automated payments, ideally monthly (though quarterly might be more appropriate for those with their own businesses or farms).
The conventional wisdom in Pakistan is that to save, one needs to control their spending. We reverse that logic: we say you should figure out how much you need to save, automatically have that amount deducted from your bank account every month or quarter, and you can then spend the rest of your income on whatever you want.
There is, of course, more to investing than these basics, but those are the parts of investing that we handle on your behalf. Following these rules, and having the discipline to stick to your plan, is likely to result in significant wealth accumulation over time.
Interested in learning more about automated investing plans? Have another question about personal finance? E-mail your questions to [email protected]. Your identifying information will be kept completely confidential.