As someone who would want to create wealth in her/ his lifetime, you should know the connection between passive income and wealth generation.
Passive income, as we saw in Save 10 per cent, and earn in crores yesterday, can be a great facilitator for wealth creation.
Today, we will learn the art of four squares and how they can take us forward in realising our dream. Here goes:
Rahul finally realises that whether he wants it or not, he will have to play the game of creating wealth. When he understands that it is easy to be a winner, he shows interest in learning the right steps.
Like in any other game, the starting point is keeping score of where he is and whether he is making good progress. In the wealth game, a four square scorecard is useful; the squares denote income, expenses, assets and liabilities.
~ A student not earning today can mention his allowance in the Income Square.
~ The Expense Square will be utilised to record his various expenses on transportation, entertainment, maintaining friendships and others. It will give him a good idea of where there is potential to save.
~ The Assets Square will show him where these savings are going -- whether these are just being kept in cash, as bank deposits or if he is investing some of this money in stocks, real estate and other asset classes.
~ The Liabilities Square will show his various loans, outstanding credit card amounts and interest rates on various loans.
The best thing he can do is to start building his Assets Square -- that is the batting or run-making square.
He should develop a basic understanding of various asset classes like stocks, real estate, debt and others. He should talk to experts, read good books, magazines and reputed business dailies on the subject. He will get a good idea of where to allocate his savings.
Actually, starting to invest and monitoring his investments will be the best learning experience. He should start early even if the sum to be invested is small. Very soon, he will be on a sharp learning curve. The best way to guard against wrong advice will be his growing self-knowledge.
He told me he is fond of cricket. It is very advantageous to think of various asset classes in terms of cricket. If I tell him that stocks are an integral part of the portfolio, there is a possibility that he might not understand the significance of the statement fully.
But I can tell him that leaving stocks out of his portfolio is as silly as Sri Lanka leaving out their captain Mahela Jayawerdene (or Australia leaving out Mathew Hayden and Ricky Ponting) for the World Cup final because Mahela took undue risks while scoring his century in the semi final.
Similarly, the role of a multi-faceted versatile asset class like real estate can be compared to that of a good wicketkeeper-batsman like Gilchrist or Sangakarra. Investing in debt (fixed deposit, for example) is the steady batsman to be deployed when the conditions are tough.
He is also under the false illusion that a good return can be made by taking only big risks. I told him that it is not true and returns can be made at minimal risks. What is important is the way in which asset classes are deployed. Again, the analogy of top batsmen makes it easy to understand. They make runs consistently and rapidly by using certain techniques. By just following principles of diversification, appropriate time horizon and valuation, he can get the most out of various volatile asset classes.
Rahul is now worried about the opposite dimension of going overboard -- he has seen his friends getting totally obsessed about their investments. There, he has to keep his priorities right and take a long-term perspective on his investments. Economic fundamentals do not change in a hurry and investments with a long-term horizon prove to be the best performers. There is not much value addition in fretting about the stock movements on a daily basis.
Moreover, just a broad understanding of various asset classes is sufficient; the detailed part can be outsourced easily.
For example, the potential of stocks can be realised easily by investing in good mutual funds. Actually, it is the asset allocation part that accounts for 95 per cent of the portfolio performance while individual stock or security selection accounts for only 5 per cent.
Unfortunately, we spend more time on individual securities where we have a tremendous opportunity to save time.
Rahul will do well to inculcate a lifelong good habit by spending just a few minutes on a good business daily, where he should know the expected rate of economic growth rate, inflation, currency, some basic interest rates like the 10-year treasury bond yield (it is the risk-free post-tax interest rate offered on the government debt that is often used as a benchmark to compare one's investments) and index valuation ratios like P/E and PEG (To understand P/E and PEG better, read 'How to pick the right share'). These are easily available and their movements will stimulate interest in finding out why the indices are moving up or down.
Rahul should also monitor and evaluate his portfolio performance on a regular basis.
He can measure his total portfolio returns against a broad benchmark that should include the real GDP growth and inflation.
Additionally, he should also measure the performance of specific portfolio components against specific benchmarks. For example, a diversified large cap fund performance should be seen against the Sensex and a midcap fund against CNX midcap index and so on.
Summary
~ It is imperative Rahul start by organising his financial information as the first step.
~ He should then learn the basics of various asset classes and start investing even with a small sum -- the best way to play the game.
~ This learning can then be finetuned by reading business newspapers, talking to experts, monitoring and measuring performance.
~ The benefits of educating himself on the wealth game are truly disproportionate -- very good results can be achieved by making some simple and easily implementable steps.
Part I: Save 10 per cent, earn in crores
Dr Sanjiv Mehta is the managing director of www.financedoctor.biz, and author of the recently published book, Winning The Wealth Game: Cricket Strategies For Financial Freedom.