Personal Financial management (03Oct2021)

Personal Financial Management

3rd October 2021

This is part of my financial review and please do not consider this as financial advice.  Kindly perform your due diligence.

Introduction

Financial Management is an important part of our lives as we work towards financial independence.  

From a recent Forbes article “5 Steps To Plan For Your Financial Independence Day”, author Mr Erik Carter provided a good definition of financial independence.

“Financial independence is a state of being in which you don't have to work to pay your living expenses. You may decide to retire or you may choose to work because you want to, not because you have to.”

The link to this article can be found below:

https://www.forbes.com/sites/financialfinesse/2021/07/05/5-steps-to-plan-for-your-financial-independence-day/?sh=515fc12c2872  

Financial independence is a goal all of us can work towards.

For us to work towards financial independence, we should put together a financial management plan.  Let us start with Senator Elizabeth Warren’s 50/30/20 plan for a start using our annual income and expenses as an overview.  Senator Warren (a Harvard law professor then) and her daughter, Amelia Warren Tyagi, wrote the book “All Your Worth: The Ultimate Lifetime Money Plan” where she popularized 50/30/20.

50/30/20

For 50/30/20, it divides our spending into 3 categories (with their targeted percentage of total net income):

Needs (50%) + Wants (30%) + Savings (20%) = Net income (take home salary net of tax, government deductions).

 

Net Income

To calculate our net income (as an individual or a household), we are looking at the net amount of money after the tax and government relevant deductions.  When we look at this annual net income, we should include any bonus, dividends and earnings from our investments.

Benefits of an annual overview

For a start, it is important to list down the expenses over one year and group them into the above categories.  I have found that I have missed out on some expenses that require an annual payment.  These include annual insurance premiums and subscriptions like Google1, VPN, Microsoft, iCloud, Dropbox, etc. 

Challenges in categorizing

It can also be difficult to categorize some of the items.  For example, it is recommended that monthly subscription of our internet and mobile plans to be put under “wants”.  In reality, most of us cannot do without WiFi and mobile plans especially working from home or remotely.  For me, I put the monthly mobile and home internet services under “needs” instead of “wants”. Some of us bought insurance linked with investment.  Thus, this should be categorized under “savings” instead of “needs”.  If we are unsure of how to categorize some items, I will put them under “needs” just to be prudent.

Stage of life

At different stages of life, we may need to re-allocate the 50/30/20.  When we started to work, single and yet to have our place, we can probably increase our savings target.  For those who have schooling kids, the tertiary education fees can weigh heavily for some years.  This can cause the “needs” category to be overweight beyond 50%.  While it can be impossible for us to reduce the spending on “needs”, we can consider cutting down on our “wants” for these few years.  When the kids are out working, we can find ourselves in a season where we can save much more with kids being independent and having lesser long-term debts.  Thus, 50/30/20 is a guide and not a rigid structure.

Benefits of differentiating needs and wants

This list of needs and wants is important.  This exercise is needful as we identify expenses based on their respective priorities.  To differentiate, the “wants” are items that are good to have, things that we can leave without.  As we age, our definition of “needs” and “wants” can differ.  When we were dealt with some challenging times, we can refer to this list of “wants” and re-direct these funds for other needful uses.  

Key steps of financial management

After we have spent time to get the list of expenses (into the buckets of “needs” and “wants”), there are a few areas that I would propose for us to look into.

Outstanding debts

We will need to identify any outstanding debts first.  Debts demand high-interest repayment should be paid off first before we look into savings.

Rent or Mortgage

Some of us would rent a place as we save up for the deposit needed to purchase our home.  Getting a home is an important milestone for us starting our families or living on our own.  Beyond putting a roof over our heads, most of us create wealth (quietly) through the property.  Billionaire Andrew Carnegie famously said that 90% of millionaires got their wealth by investing in real estate.

A good article can be found below about property: https://www.cnbc.com/2019/10/01/real-estate-is-still-the-best-investment-you-can-make-today-millionaires-say.html 

The first property that we own should be for our homestay and not be viewed as an investment tool.  At a later stage where our lifestyle, health needs differ, we may consider selling off the property and moving into a different property.  Till we reach that life’s stage, a home is important for us to build our family, career and businesses.  When we have sufficient funds for another property, we can also consider adding a property to our asset portfolio.  Let us do our due diligence to qualify our loan limits and research on the homes before we invest.  With property prices peaking in several countries like the USA, it may be wise for us to consider this option later as a housing bubble threatens. 

Emergency Funds

We have been advised to have sufficient emergency funds to last 6+/- months should we found ourselves without our regular income.  This would allow us some breathing space as we search out jobs and businesses, knowing that the family would be able to cope for the next few months.  This would be the time when we would reduce our spending on “wants”.  I recommend this emergency funds to be 9 months (based on “needs”).  

Financial Planning 

We should also seek out insurance coverage to protect ourselves (and family) in event of:

 Death,

 Critical illness 

 Total permanent disabilities and

 Hospitalization

We should also look into asset-related insurance for our properties, vehicles and also travel.

With no more high-interest debts, housing and emergency funds in place, we can turn our attention to the next stage of financial management – savings.

Savings need to work for us

Savings is not the money that we are left with at the end of the month but it should be the amount that we choose to set aside first when we receive our income.

Savings needs to be put to work.  Savings as cash in the bank is not the best way to prepare for retirement.  With the current inflation rates exceeding the interest rates, we are getting negative (real) returns if we just put cash into banks.  Using Singapore as an example, our national bank offers a savings interest rate of 0.05% per annum against CPI-All Items inflation rate of 2.4% (y-o-y in August) as per the Monetary Authority of Singapore’s August report released on 23rd September 2021 (https://www.mas.gov.sg/-/media/MAS/EPG/CPD/2021/Inflation202108.pdf).  This will imply that our deposit in the bank will lose about 2.35% in real value per annum.  If we keep $1,000 in Singapore bank one year ago, our (real) value turns out to be an estimated $976.50 as things get more expensive due to inflation.

There are various investment instruments available in the market that we can consider investing in.  These vary with different risk to reward benefits.  Let us choose the right ones that fit our lifestyle, risk-reward appetite.  Being prudent, the returns should beat the ongoing inflation at about 2.4%.  In Singapore, our retirement funds (known as CPF) payout annual interest rates approximately 4% (pending your age bracket).  Thus, I would be expecting more than 4% annual returns if I am to invest in various assets.  If I cannot get such returns from my non-CPF investments, I should put the money into CPF instead.

I have an interest in the stock market and has been setting aside part of the monthly savings into stocks.  I hope to invest in equities to help me make money that beat the target of 4% annual returns.

Motley Fool shared that “The S&P 500 gained value in 40 of the past 50 years, generating an average annualized return of 10.9% although only a handful of years came within a few percentage points of the actual average.” ( https://www.fool.com/investing/how-to-invest/stocks/average-stock-market-return/ ). 

Being a passive investor, I do not have the time to monitor the market and thus, I am better suited to invest for the longer timeframe in years.  This does not require me to stay up through the night to monitor the US market from Singapore.  Using the S&P 500 index as an example, if we invest $1,000 in Jan 2011, this will be worth approximately $3,100 after taking out the impact of inflation by Dec 2020.  If we would research into property, cars or household items before we buy them, we need to do the same for investments.  

Conclusion

50/30/20 is a start for our financial management.  We can simplify this to the 80/20 rule which allocates 80% of net income for expenses and 20% for savings.  For a start, we can start with 20% savings and let us aim to reduce our expenses and increase our savings over time.  I target 30% savings as the next milestone.