How to retire early? some guidelines to manage your finances better

“How can I retire at an early age and pursue my other interests?”

Many of us would have thought about this a number of times during our respective careers. However, a vast majority of us would have left it just as that – a thought! Some might have dismissed it as a pipe dream, whereas others didn’t pursue it as they lacked the will and the skill to make this dream a reality!

However, retiring early need not be simply a dream. This article discusses a framework that may be adopted by everyone to manage one’s finances better and to achieve the various financial goals that we may have set for ourselves.

Live within your means and control your expenses

This really sounds like an advice from our grandmothers! But this is indeed one of the golden rules that would help us achieving our set financial goals.

As you start a job or a business and starts earning a regular income, it is tempting for you to want to spend your income on the items that may seem to provide happiness to you – the iPhone that you always wanted to buy; the expensive watch that you want to gift your father; the dream car that you want your family to own; the overseas vacation that you had always dreamt of……The list is endless. Many a times, one even spends on such items by borrowing on his / her credit cards.

But it is really controlling this very urge to spend your income on things that ‘can wait’, and instead starting to invest to build the corpus necessary for your retirement and other important financial goals in the future, would take you a step closer to actually realising your retirement dream!

We have always been told - penny saved is penny earned. Indeed, not spending your hard-earned money today and investing it instead would mean that the money saved today will start working for you several years down the road.

Does that mean that one should not spend his / her income and live life like a miser? Absolutely not! Afterall, we have only one life and we all want to enjoy it to the fullest extent. However, it does mean that we simply need to be firmly focused on our financial goals and prioritise investment over wasteful expenditure. Perhaps, some self-imposed rules such as those given below, may help us in maintaining such a focus and discipline:

• I would invest at least 50% (could even be more) of my income each month
• I would not spend my money on an item that I can’t afford to buy from only the interest income (i.e. not touching the principal amount itself) on my savings / investments
• I would never borrow to buy a white good such as a car

Instead of investing what is left of your income after all your spending, you should really be spending only what is left of your income after investing for the future!

Start early, investment for the long-term – benefit from the power of compound interest!

“Compound interest? I forgot about that long ago!”

Well, you need to re-learn it, as it is the power of compound interest that will help deliver your financial goals!

See the example below. A Rs.1,000 invested today, when you are 25 years old, will become Rs.1.1 lakhs after 40 years when you are 65 years old, if your investment earns a rate of interest of 12.5% p.a. Instead, if you invest only when you are 35 years old, you will get only Rs.34,243 when you are 65 years old!

If you are disciplined enough and invest Rs.1,000 each year, it will become a whooping Rs.8.8 lakhs after 40 years, if your investments earn a rate of interest of 12.5% p.a.!

This is not a rocket science. The longer you invest, the higher the amount will be – thanks to the power of compound interest.

So do yourself a favour – start as early as you can and invest your hard-earned (and not spent!) money for the long term. Let your money work for you instead of you continuing to work to earn money during retirement!

Invest wisely!

One of the common mistakes people make, is not differentiating between ‘savings’ and ‘investments’.

Savings are made in avenues such as savings bank account, fixed deposits etc. These avenues typically carry no or very low risk, but provide the maximum liquidity – i.e. you should be able to withdraw your money to meet your cash needs or to meet emergency expenses. Surely everyone needs to have some of their funds in such avenues. However, too much of your money parked in ‘savings’ type products would mean that the overall interest rate earned on your portfolio would also be low, at times even lower than the inflation itself, leading to a reduction in the purchasing power of your hard-earned money.

Instead, you should park a significant portion of your funds in avenues that are for longer term and provide a return that is higher than the inflation itself. It is important for you to take some calculated risks, in order for your funds to earn a much higher return – the only way to grow your wealth over the longer run. Remember – no risk, no reward! And it is really when one is young, can one afford to take some risks and invest funds in categories that may provide a high overall return over the longer period (e.g. equity shares, equity oriented mutual funds, equity oriented unit-linked insurance plans etc.)

On some days, you may make a ‘profit’ through trading, but on others, you will suffer a ‘loss’. Investing for the long term involves selecting an appropriate asset class that is fundamentally strong. Also, albeit you need to monitor your investments on a regular basis, unless there are any fundamental reasons to change your investments, you should essentially be staying invested for a 10-20-30 year period, to be able to maximise your returns.

Finally, one should be focused in building assets and investment that generate a high, inflation-beating return, helping in building value over the long term. There is no point in investing in categories that lead to a reduction in value. For example, you may consider a newly purchased car as your asset. But the car is not really going to appreciate in value and in fact it is going to cost you money to even maintain the car in a good condition. Thus, a car may not be a good investment for you.

Don’t forget about the impact of taxation!

Many a times, we tend to look at the interest rates / investment returns offered on different products without considering the impact of taxation. For example, a 5% p.a. rate of interest offered on a bank fixed deposit is really worth 3.5% p.a., if the entire interest income is taxable for you and if your marginal rate of income tax is 30%. Comparing alternative investments entirely based on the interest rates / investment returns that are before tax would be grossly misleading and may cost us dearly over the long term.

Should you buy or rent a residential property?

To many of us, owning a residential property is much more than simply owning it – it is an emotional thing! Many of us work for a lifetime to be able to live in a property that is owned and not rented.

Those who do consider it as an investment may need to weigh in several aspects –

• If you had rented it out instead of buying it by availing the loan, would the rental outgo (allowing for any future increases) have been higher or lower than the ‘net benefit’ from owning the property? The net benefit in this case could be taken as the impacts of increase in property valuation less the monthly loan instalments and maintenance outgoes (allowing for any future increases).
• What is the opportunity cost of owning the property if you purchase it from your own funds (i.e. not by availing a loan)? Would the net benefit of owning the property (i.e. the impacts of increase in property valuation less the monthly maintenance outgoes (allowing for any future increases)) be higher or lower than the net investment return you would have obtained on alternative investment categories (e.g. equity shares or mutual funds etc.) over the longer term?
• What is the location of the property and the likelihood of an increase in the future valuation in that location? For example, in large cities, the property valuations may not increase or they may not increase as much as compared to smaller, but developing towns. Are there any headwinds likely in the property market, causing the valuations to come down?

As can be seen, whether owned property is preferred over rented depends on a number of factors and personal circumstances. However, one thing is for sure – if one does want to buy a residential property, it is better to buy it as early as possible in one’s career, when the age is on your side and you can afford to take risks, rather than waiting for the right time when you would have built a sufficient corpus of your own.

Don’t put all your eggs in one basket – diversify, monitor and manage your risks

Another important principle in managing your finances!

It is always advisable to diversify your risks and not let your fortunes be dependent only on one or two investments. Diversification may also mean that you may not be able to maximise your wealth – as you may have to invest some of your money in instruments that may not give you a high return. However, this is still preferred over the scenario wherein, in pursuit of the highest possible return on your investments, you end up losing all of it because, for example, the equity share / company that you ended up investing in becomes bankrupt!

It is also important to regularly monitor and manage the various risks that you face:

• Do you monitor your personal finances regularly (e.g. every six months or so) to ensure that you are on the right track, and if necessary, take corrective actions? For example, it is important to take corrective actions such as - cutting down on your monthly / wasteful expenditure or re-balancing your investments, in order to help you achieve the set objectives etc. – at an early stage, before it becomes too late. Regularly monitoring your financial position would help you achieve this.
• Do not believe on market rumours, ‘helpful tips’ provided by your friends etc., when it comes to your personal finances. Your investments require an informed management and not a haphazard approach. Thus, if you do not understand, simply seek advice from professionals who do! But remember - there is no alternative to learning the tricks of the trade yourself, even if you have a professional advisor.
• What would happen in case of an unfortunate event such as an accident resulting in your disability, or a hospitalisation for a sustained period causing a drain on your finances, or even your untimely death? No planning for retirement would be complete until one has also provided for appropriate insurance products to ease the financial burden caused by such unfortunate events.

A systematic approach in managing your financial matters such as that outlined in this article will surely help you in achieving your dreams!