How to grow your wealth.

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How to grow your wealth

Cash is trash. Counterintuitively, holding on to cash as savings is a sure shot way of reducing your wealth. Growing wealth is essentially a race against inflation. To win, the return on your investments should exceed the inflation rate of the country.

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The strategy to build wealth is pretty simple:

Increasing your income and reducing your expenses.
Investing the savings in compounding assets.

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Let’s look into a few crucial things you need to be aware of, while making decisions on investments.

Money illusion

Money illusion is the human tendency to think in nominal terms instead of real monetary value. Nominal value is measured in terms of money and real value is measured in terms of goods and services that can be purchased. For example, a 5 % salary hike with a 6 % inflation is in reality worse than a 2 % hike when the inflation is at 1 %. But most people would be more content with 5 % because we think in nominal terms. It is really strange and irrational but it happens to everyone. What actually matters is, how much can you buy with the money you have, not how large the numbers are.

It takes a while to get used to thinking about money in real terms by adjusting for inflation. Here is an inflation adjustment calculator. Look at the ‘Reduced amount’ and check out how much ₹1000 would be worth after 10 years, with an annual inflation of 6 %. Its ₹558!

Loss of purchasing power of ₹100 over a period of 10 years with inflation at 6%
Here’s a fun fact: It is well known that the top largest box office movies of all time is ‘Avatar’ with 2.8 billion USD in revenue. We’ve been lied to! Actually it turns out ‘Gone with the Wind’ (393 million USD revenue) from 1939 is actually the largest box office hit of all time. How? When you compare the two revenues using inflation adjusted numbers ‘Gone with the Wind’ generated 3.44 billion USD in today’s value. ‘Avatar ’ actually ends up 15th on the list.

Here’s another great example to illustrate money illusion. Lets say you were earning 10,000 ZWL (Zimbabwean Dollars) in 2018, you might have received a salary hike of 150% and your salary would be 25,000 ZWL in 2019. The 25,000 is the nominal value of your salary, but compared to 2018, in real terms your salary is actually ~9000 ZWL. Yes, I’m not joking, even with an absurd 150% salary hike, you became poorer over 1 year. Why? Because the inflation rate in Zimbabwe was 175% in 2019!

I hope now you can see why its really essential to look at inflation adjusted numbers for every financial calculation.

Compounding

Humans find it really hard to grasp the impact of compounding. Imagine you have a sheet of paper and the thickness of the sheet is 0.05 millimeters. You fold it in half, and then you fold it again in half and so on, so that it grows thicker as you go. Here’s a question for you, if you could do 42 folds like this, how much do you think the thickness of the paper would be? Just take a calculated guess!

The thickness would be the distance between the earth and the moon!

That’s the power of compounding. Albert Einstein allegedly called Compounding as the Eighth wonder of the world and for very good reasons.

With compound interest, you don’t just gain interest on your investments, but your interest also gains interest. Lets look at an example:

If you invest ₹10,000 in something that returns 12 % a year, after 10 years this would be ₹31,000, but if you keep it for another 10 years this would be ₹96,000 and another 10 years would make it ₹3,00,000! This is without adding anything to your initial investment.
Now lets say you start adding ₹5,000 every month to the same fund, in 30 years, you would have amassed ₹1,55,59,665.66!! Isn’t that crazy?! In total, you would have invested just ₹18,00,000. That’s called letting the money do the work for you! That number looks huge right? But like we saw earlier, lets not fall into the money illusion trap and always remember to look at inflation (assuming 6%) adjusted numbers. In 30 years, after adjusting for inflation, the ₹1.5 crores would actually be equivalent to what ₹27 lakhs can buy you today! If you are curious, I used this link for the calculation.

Stock market

The market always goes up, it’s true. If you look at the stock market of most developing and developed countries over a long term period, the stock market always goes up. There will be crashes and recoveries, ups and downs. It is a roller coaster! But one thing is for certain, the market always recovers. The market always goes up because human productivity is constantly improving and companies are always innovating. Businesses are trying to stay ahead in the game to beat their competitors offering high value to their customers.

Investing in the stock market is really the best way to grow one’s wealth. If you are a beginner to the stock market, the best way to start is to invest in an index fund of the largest companies like Sensex or Nifty 50 in India and S&P 500 in USA. Lot of hedge funds try to beat these index funds and many fail. So its safe to say that as beginner investors, it is best to allocate some percentage of your savings into index funds. Of course, once you have some skin in the game you can explore and find companies that you think have good future prospects and start allocating to individual companies. An important thing to note is that stock market investments should ideally be thought of as a long term (5 to 10 years at the very least) strategy to build wealth. It is not safe to invest money that you will need in a few months or a year. There are better alternatives for short-term low-risk investments which I will talk about in another article.

Time in the market vs Timing the market

Do not believe anyone that says they know where the stock market will be in next 6 months or 1 year. In the short term the stock market is unpredictable. All the information that you can get, every other market participant can also get, unless its insider information in which case you’ll end up in jail! Trying to time the market is a herculean task. The stock market is also an emotional rollercoaster and its definitely not worthwhile trying to time the lows and highs. A simpler way to grow wealth is to stay in the market for a long period of time and cost averaging your positions. Cost averaging is simple, buy the same stock/index every week/month irrespective of the price so that you reduce the risk of making bad decisions. You end up buying at lows and highs and that averages your overall cost. Investors can completely avoid the mental gymnastics of handling fear and greed that come with the fluctuations of the market. If you’re still not convinced that timing the market is not the best strategy, here is something that might:

Embracing loans

Most of us have been taught to save our money and stay away from loans, and when you do – to try and pay them off at the earliest. Although this is good advice, it comes from an era when the financial system worked in a different way. Prior to 1970s most countries were in a pseudo gold standard, when credit was not so easily available and inflation was not as persistent as today. We have already seen how inflation can eat your money slowly over time. How can we use this information to our advantage? Fixed rate loans!
Yes! that’s right, inflation benefits the borrower. When you take a fixed rate loan in an inflationary economic system, your debt repayments (EMI) are fixed but they reduce in value over time. Even though you are paying interest in addition to the principal, since the money is losing value and you are paying the same fixed amount, you don’t end up paying the entire principal and interest in real terms. Confused? Let me explain this by taking an example.

Let’s say you have borrowed ₹10,000 at an annual interest rate of 8 % for a period of 10 years. Let’s also assume that the annual inflation rate in your country is 6 %. You would end up paying ₹14,559.32 in total by the end of 10 years. However when you adjust it for inflation, in real terms, you would have only paid ₹10,913. (Link for calculator)
Ok so loans can be helpful, so what do we do with that? I am definitely not saying that everyone should be borrowing a lot of money. If the interest on your loan is close to the annual inflation rate, then you should consider keeping the loan and use any extra money to invest in compounding assets. If you have some cash in hand I’m sure you would prefer to pay off your loans first. Its a huge mental relief for sure, but there is an opportunity cost to it. It might be worthwhile to consider investing the cash rather than paying off the loan (only if its a low interest loan). However, this is not applicable always, especially in periods of recession, or when the stock market is at all time highs. I guess the take away from this should be that loans aren’t all that bad, they can actually be really beneficial in growing wealth over long periods of time.

Important Note: High interest loans should be paid off as soon as possible.

Other Investments

Real estate is another investment that everyone wants in. Its great in a way because you almost always buy real estate with a loan, so you are taking advantage of inflation as we just saw. There are plenty of other factors to consider here. I will have to dedicate an article just for real estate.

Cryptocurrencies have been all the buzz last couple of years. Just a bubble filled by hype or real prospects? I’ll be writing about the Evolution of money and will cover how Bitcoin specifically can be the money of the future. Once you are convinced, I am sure you will choose to allocate some percentage of your investments towards Bitcoin.

Portfolio

Here are some portfolio allocation charts that are good references regardless of where you are in your journey as an investor.

Portfolio 1:
This portfolio is for people who do not have a property or don’t plan to buy one in the near future. The miscellaneous section can include individual company stocks, commodities, cryptocurrencies, real estate investment trusts etc. Bank deposits are generally low yielding but usually slightly higher than the inflation rate, so you’re still increasing your purchasing power.

Portfolio 2:
This portfolio allocates a quarter towards real estate, for people who are paying EMIs towards a property or planning to buy one in the near future.

The key to investing is to start. Do not hesitate to enter the markets with the fear of losing money in the short term. The best thing to do is to start off with a small amount. Once you have your skin in the game, you will develop an interest towards learning more and that will give you more conviction. If you are ever in doubt, just look at the images in the section Time in the market vs Timing the market. In the long run, all that matters is how consistent and committed you have been in the market.

Tracking your expenses

As boring as that sounds, it’s probably one of the most important things one should be doing. Categorizing your expenses and tracking your savings can help you see what your essential and non-essential expenses are. A step in the right direction would be to reduce the non-essential expenses and increase your income.

Try doing side hustles

Do you have a passion or a hobby? Think about how you can convert it into a side hustle. Even if its a really small amount, it can have a huge impact over time with the power of compounding.

Things may come to those who wait, but only the things left by those who hustle. — Abraham Lincoln
Reduce your expenses

Think deeply about your expenses. We live in a world where consumerism is rampant, and its easy to get caught up and follow the trend of buying new things all the time. Social media is driving consumerism up by a larger extent.

Spending money to show people how much you have is the fastest way to have less money — Morgan Housel
Last but not the least, most financial experts advise to keep away 6 months of your living expenses in an emergency fund so that you are covered for the rainy day.

CONTRIBUTED BY Curiousotters

Read More: How To Start A Business With No Money

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