Financial mistakes in our early years have adverse consequences later on

In the previous part of this series, we discussed how financial mistakes that people make in their twenties, have repercussions on their retirement planning later on in life. Please see our blog Financial Planning mistakes in early years have adverse consequences later on: Part 1. In the second part of this blog, we will discuss some common financial mistakes which we make in our thirties.

Financial mistakes in the thirties

In your thirties, your income is higher but at the same time, you most likely have a family to take care of as well. The inflation in education cost is usually twice the normal inflation and as such most young parents underestimate their children’s education when they are planning a family. Therefore despite higher incomes, many people in their thirties struggle to save more. Cutting down on other expenses is not as easy as it seems as spending is habit forming and is more difficult to change than we would like to believe. The CFO of a major MNC, when speaking about cost reduction in his company, once lamented to me that, “Profligacy is so much easier than austerity”. Most people do not have a monthly budget and therefore have no idea how much they are spending or saving, till they see their bank balance at the end of the month.

By the time people reach their mid thirties or earlier, buying a house is a major aspiration for most families. Since most people buy a house by making a small down payment themselves and borrowing the balance amount as home loan many people over extend themselves while buying a house. Consequently they end up in a situation where they have very little savings after paying the home loan EMI, while they remain saddled with the debt. Home loan borrowers should note that for the first 7 to 8 years, 65 - 70% of your home loan EMIs goes towards interest cost. Now if interest rate goes up, as was the case from 2012 to 2014, many home loan borrowers saw their loan tenure extending beyond 20 years even after paying regular EMIs. How much EMI can you afford? The most commonly used rule of thumb is that your home loan EMI should be at most 40% of your gross monthly income. Many home buyers actually follow this thumb rule. But following a thumb rule without due consideration towards your personal financial situation and goals can have very adverse consequences. You should factor in your household income, expenditure, investments and liabilities in your real estate investment decision. Good financial planning practice suggests that you should set aside sufficient part of your savings towards adequate life insurance, health insurance, emergency funds and your long term investment goals. Financial planners recommend that you should be able to save at least 15% of your monthly income, after paying the EMI and other expenses.

The 30s is also the busiest and the most crucial phase of your professional careers. You think that, the potential of career progression is highest at this stage of your life. You are so busy that you do not have time to think about your family, let alone your personal finances and investments. As someone, who has crossed the thirties and has placed probably as much importance to his career as you are doing right now, let me tell you, there is always enough time. Many things that we do for our professional careers do not have very high returns in the long run. By devoting a little time to your personal finances, you can earn as much as 10% incremental compounded annual returns on your investment. That will go a long way towards your long term financial goals, without having to sacrifice anything at all on the career front. There are several examples of how we lose out on returns by not devoting the little bit of time and effort required. Many people leave tax planning till the very end of the financial year. If you make your 80C investments at the end of the year, i.e. March, instead of beginning of the year, i.e. April, you can lose between 8 to 20% returns on your 80C investment. Another, example is keeping substantially higher balances in our savings bank account than what we usually spend, because we do not have the time to invest it. The opportunity loss of keeping money idle in your savings bank over a long period of time can be quite substantial. It does not take a lot of effort to look after your personal finances. If you can spend even a couple of hours every month to review your personal finances and investments, you will be able to manage your own finances much more efficiently.

Many people who buy their life insurance policy in their 20s do not review their life insurance needs even after they are well into their thirties. The life cover that you bought when you did not have children will most probably not be sufficient, once you have children. Our financial situation changes with time. Compare your current income with your income ten years back. Hasn’t your income grown several times? Your lifestyle would also have changed. If you bought a life insurance plan ten years ago based on your income back then, the sum assured will not be enough to meet your family’s current lifestyle and needs, in the unfortunate event of an untimely death. By the time people realize this and buy additional life insurance, they have to pay much higher premiums for the same sum assured.

Most investors do not have any financial plan, formal or informal. They invest mostly on an ad-hoc basis, based on advice of family members, friends and colleagues. What is a financial plan? In its most basic element, financial planning is really about assessing your future needs. For example, if you are in your mid 30s and you had your child in your early 30s, your child is still quite young. However, you should also realize that your child will go to college in about 10 to 12 years. Based on current costs and inflation estimates the cost of engineering, medical, management and other professional education will be in the range of र 15 – 30 lacs. Unless you start saving and planning for your children’s education you will face a shortfall when you have to pay your child’s college expense. Since parents do not want to compromise on their children’s future, what they end up doing is, using investments earmarked for some other purpose, usually their retirement planning investments, for their children’s education. This then has repercussions on the retirement years, which ultimately then affects the child, if the child has to take care of the parents in their advanced years.

Misplaced Optimism and Unwarranted Pessimism

I have seen many young people suffer from a syndrome, which I call “Misplaced Optimism and Unwarranted Pessimism”. Let me explain what it means with the help of an example. In my corporate role a few years back, one of my colleagues asked for my help to give some career and personal advice to one of his direct reports, Arjun (I have changed the name for obvious reasons), a young MBA and a star performer in my colleague’s team. I had a long and very informative chat with Arjun. The contents of the chat are to a large extent, irrelevant to the topic we are discussing today. But there were two points, which I think are relevant. Firstly, Arjun told me that he expected a salary increment of 15 – 20% every year, which may be the expectation of many young people reading this blog. Arjun was a strong performer and in the 5 – 6 years of his career till that point, Arjun actually got that kind of increment on an average and therefore it had become his expectation. However, expectation is one thing and reality is another, a point which we will revisit later. Secondly, I asked Arjun, how much he invested in equities and if he did, what was his expectation from investment in equities. Arjun said he does not invest in equities because it is risky and all his investments were in fixed income and real estate. Here is my point, which I tried to articulate to Arjun. If Arjun did not expect equities to give 15 – 20% returns, how did he expect to get a salary increment of 15 – 20% every year from the company? Let me explain further. Equity returns are a function of two factors:-

• Earnings (EPS) growth of the company


• P/E expansion of the share price of the company

Let us assume that, there is no P/E expansion. If Arjun did not expect the company’s earnings to grow by 20%, how did he expect that the company will pay him an increment of 20%? Is it not contradictory? I admit that my argument is too general, but logically speaking, is it not valid? It is true that top performers earn more than average performers, but I think my argument is valid in most cases and over a period of time. However, I am quite sure, Arjun did not agree with me when I made my argument, but when the economy slowed down, Arjun did not get the 20% increment he expected; his increment was more in line with the prevailing inflation rate. What Arjun did not realize is that, the revenue and profit growth of the company can slow down due to economic factors, which are beyond an individual’s control. The reality is that, your salary, especially if you are working in a private company, is linked to the performance of the company. On the other hand, there may be sectors which may be performing better than the sector that you are working in. If Arjun invested his savings in a good diversified equity fund, he could have got nearly 20% annualized returns over the last three years, which could have compensated Arjun’s lower than expected salary increments over that period. This is what I mean by, “Misplaced Optimism and Unwarranted Pessimism”. I totally agree that, unless you are optimistic about your career prospects and earning potential, you will not be motivated enough to do well in your career. Therefore, irrespective of market conditions, you should always give 100% to your job. That said, you should also understand the dynamics of a market driven economy. If your investment planning is based on misplaced optimism and unwarranted pessimism, it can have severe consequences as far as your goal planning is concerned.

Consequences of not planning investments early in your career

Let us assume you have a retirement planning target of र 1 crore based on today’s costs. We will see how much you have to save on a monthly basis to meet your retirement target on an inflation adjusted basis.

There are two important things you should note in the table above, both which have a substantial impact on your financial goals.

1. The earlier you start the better. Assuming you can get 15% return on your investment, you can meet your inflation adjusted retirement planning target of र 1 crore, by investing a little over र 6,000 per month if you start at the age of 30. On the other had if you start at the age of 50, you will have to save nearly र 60,000 a month to meet your retirement planning objectives.


2. The more risk you can take, the less you need to save to meet your financial objectives. Your return on investment has a direct correlation with the risk you can take. Your risk tolerance decreases with age. For example, at the age of 50, typical asset allocation guidelines will require you to invest 50 – 60% in equity and 40 – 50% in debt, which will imply that you can expect a return of 12 – 15%. On the other hand, at the age of 30, you can invest 70 – 80% in equity and the balance in debt, which will imply that you can get around 15 - 17% returns. Therefore, this further reinforces point 1, which is that, the earlier you start planning for retirement the easier it is for you.

The table above demonstrates the power of compounding. The people who are able to take early retirements are the ones, who recognize this power early in their careers and start working towards it.

Conclusion

In this two part series we have discussed some common financial mistakes that we make in the early years of our career, in our twenties and thirties. These can have a significant impact on our financial lives, since we are living in times where we cannot take anything for granted. On the other hand, if you develop the discipline of financial planning from an early stage in your career, it is very likely that, you will have no difficulties in meeting all your financial objectives.