How to achieve financial freedom (India)?

The very first step in the journey towards financial freedom is to understand some key personal finance concepts. I believe that without understanding how money works, how banks and interest rates work, how taxes work; it is very hard to understand and evaluate your investment choices and move towards financial freedom.

Financial wellness basics are simple and mostly straightforward. With a little understanding of how the financial system works we can greatly improve our odds of success in building wealth. I have attempted to break down things into nine major ideas. These should hopefully make you financially aware and help you realize the financial freedom goals you have set for yourself! It is a slightly long article, but I hope it will help you see the nuts and bolts of financial freedom!

Examples and calculations in this story refer specifically to Indian financial system, but the underlying principles are largely applicable to most free market economies.

1. Time value of money

What this means is simply that Rs 100 today is more valuable than Rs 100 one year from now! For example, if I told you that you can have either 100 today or 100 one year from now, which one would you pick? Almost all of us will pick 100 today! But why?

Since there is some value to being able to spend that money today compared to one year from now. There is also the risk that something will happen between now and then and I may not pay the 100 as promised in one year. Rs 100 one year from now may also not be able to purchase the same item compared to today (assuming some rise in prices). All this creates a difference in having 100 today vs having it one year from now, and this difference is essentially what is known as time value of money. This is the reason why interest rates exist in the first place (to compensate for the Time Value of Money).

2. Banks and interest rates

The business of banks is straightforward, they take in deposits and then make loans. The difference in the interest collected from borrowers (those who take loans from banks) and interest paid to depositors is how they make most of their money.

Deposits in banks to the limit of 5 lakh (per bank) are insured by Deposit Insurance and Credit Guarantee Corporation that is a subsidiary of RBI (Reserve Bank of India).

The choice of which banks to deposit your money in should be based on the interest rate that they offer on savings account and convenience of other services they may have on offer. Zero fee and Zero minimum balance accounts are the best.

It may make sense to have two saving accounts, one with a larger bank that has wide variety of services and branch/ATM presence where you maintain just the minimum balance and use it for convenience (since most large banks like SBI, HDFC and ICICI pay poor interest rates on savings accounts). Most remaining money that you want to keep in cash for saving/Investing and emergency use should be with a bank that pays a competitive interest rate (eg. Kotak bank).

All Indian banks are heavily regulated by RBI and your money is safe in all banks regulated by RBI. Steer clear of co-operative banks unless they have a long-established history and their membership is beneficial for you in other ways (they also tend to have poor online infrastructure and are less transparent in their functioning).

Let’s take an example to illustrate an ideal bank account setup:

Suppose Naisha has a monthly income of INR 80,000 per month that she gets directly into a salary account at HDFC bank. HDFC is one of the larger banks that does not pay good interest rates on its deposit accounts. It does offer a lot of other day to day conveniences. So, she maintains the minimum balance in HDFC (for urban areas it is usually 10,000 and sometimes waived for salary accounts) and conduct all daily transactions from this account.

Any money that is to be saved, she moves it as soon as she receives the salary to a higher yielding savings account at say, Kotak bank where she parks the savings until she can invest them thereby earning more interest than at HDFC. Naisha does not use this other true “savings” account for any ordinary expenses (except in case of emergencies). This is the account she uses for transferring money into investing accounts and placing back earned money from investment accounts.

She always maintains 3–6 months salary equivalent sum in this Kotak account as a rainy-day fund to be used only in case of medical emergencies or if she were to somehow lose her job and takes a while to find another.

If HDFC offers 4% and Kotak offers 6%, then the extra interest earned by keeping 2,40,000 in Kotak vs HDFC savings would be approximately (6–4) = 2% of 2,40,000 i.e. 4,800 per year! (It will actually be slightly more since interest is paid on daily balances and paid out quarterly, so interest earned in 1st quarter will also earn interest in the 2nd quarter and so on.)

A quick word about Inflation vs Interest rate (why is it important to earn an interest rate greater than inflation?):

Inflation simply put is the rise in general level of prices year on year. If the interest rate that we are getting on our investments (net of taxes) is not as much as the rate of inflation, then we are essentially losing money with time! Right now (in mid 2019) inflation is around 5.5% in India, and we should hopefully attempt to get this much interest on our Savings accounts.

3. Taxes

Well as they say, death and taxes are the only two permanent things in modern human life! We really need to understand how taxes impact us in long term.

The more money we make, the more government will want us to fork out as taxes (it is called progressive taxation). It is a good thing since the taxes we pay enable the public infrastructure we rely on for our daily lives and safety. (think drinking water supply, roads, law and order system and the like)

But the government also nudges saving for retirement by waiving off taxes (upto certain limit). It is extremely important that we take full benefit of this generosity offered by government in form of EEE investment vehicles (EPF and PPF). These Exempt Exempt Exempt accounts are the best that is out there since the original contribution is not taxed, nor is any interest/dividends on the principal and neither are the gains taxed).

What this means is that you don’t pay tax on amount you deposit into EPF/PPF, don’t pay tax on any interest you receive in these accounts and also do not pay any tax on any price gain — rise in value of the investment. With time investments grow and over a period of 20 years investments can grow to approximately 5–8 times the original amount (assuming doubling every 5–8 years!), and the benefit of not being taxed on interest and gains is immense, to put it mildly.

Taxes are best understood with a concrete example! So, let’s take example of Naisha again to understand how income tax works in general:

We assume that her gross salary of 80,000 per month is composed of Basic Salary of Rs 50,000 per month, HRA (House Rent Allowance) of Rs 20,000 and Special Allowance of Rs 10,000 per month. Also assume she gets an annual LTA (Leave travel Allowance) of 15,000.

Since Employer deducts EPF contribution of 12% from her salary (and contributes another 12%) to EPFO account. Employee EPF contribution: 12% of 50,000 = 6,000. (Total EPF contribution will be 6,000 + 6,000 = 12,000 (from Employer)).

HRA Deduction: This is minimum of the following three amounts — 1. HRA received from employer, 2. 40% (50% for large metros) of the Basic Salary, 3. Excess rent paid over 10% of Annual Base salary. For Naisha, assuming she lives in Delhi and pays a monthly rent of 20,000, these numbers are, 1. 20,000 2. 25,000 (50% of Basic) 3. 20,000–5000 = 15,000. So maximum monthly HRA deduction she can claim is 15,000.

LTA is based on actual travel receipts submitted, so assuming Naisha submits receipts totaling 10,000 she will get deduction of 10,000.

In addition to these deductions she will get an annual standard deduction of 50,000 (this deduction has now replaced the transport allowance and medical allowance)

Now the good part about Investment deductions:

80-C (Annual Max. 1,50,000) — This includes eligible investments: EPF, PPF, ELSS (Equity linked Savings Scheme max 50,000) and LIC premiums. Naisha has following investments that she can claim under 80C:

1. EPF contributions made by Employee = 6000*12 = 72,000

2. PPF contribution: 50,000

3. ELSS Investments: 28,000

Other deductions:

80-D: For medical insurance premiums paid (Annual Max. 25,000 for self, 50,000 if parents included on policy). Naisha paid a total of 15,000 in medical premiums for the year for herself.

80-TTA: (Annual Max. 10,000 — Interest income earned from a savings account up to Rs. 10,000 is tax deductible) Naisha had an interest income of 11,000 from her savings accounts. (Out of this 10,000 will not be taxable due to 80-TTA)

Let’s calculate her tax for the year, considering the details above and no other income sources for the year. Please note that since the actual calculations/tax brackets may vary with changes in tax laws, treat the calculations below as just a guide to understand the taxation structure.

If Naisha did not take advantage of 80C other than mandatory EPF contributions, she would have paid an extra 20,000 in taxes! (20% of 1,00,000, since her 80C deduction would have been only 50,000). In fact, one would save even more tax via 80C if their taxable income was higher and being taxed at higher rate of 30%.

I recommend making most 80C Investments into EPF/PPF since these are EEE and will be more beneficial in the long run due to gains being tax exempt! ELSS investments, while excellent in their own right are not exempt in gains/interest earned. Equity investments can be made outside of the 80C exemptions as part of your Investment portfolio (which I will talk about later). For simplicity I have not included any NPS contributions in the example, but NPS is also a great way to save on taxes and build up assets towards your retirement.

If you want to check with your own numbers or want to understand how tax will change if you take certain actions like contributing to PPF, use any of the many available online tax calculators that will give you numbers calculated based on latest tax regulations.

Recent changes to tax regime allow for lower tax brackets if you forego most deductions. This may look attractive to some, but for people who are availing 80C deductions fully should still come out strong opting for the old regime. And of course, saving for your future should be a priority regardless of the tax code incentives and the chosen regime.

4. Debt and Loans

A lot of us have some kind of loan, student loan for higher studies, personal loan, purchases made on EMI, home loan, auto loan or any other type of loan. All loans have a common feature, that is they need to be paid back with interest.

We should be very careful about taking on loans of any kind without doing a cost benefit analysis. Loans can severely impact out ability to save for our future, they can be burdensome and can even cause stress. But the most important issue with loans that are taken for consumption of any kind is that buying anything by taking out loans makes the cost of ownership higher! For example, let’s assume you buy a car that costs 10 lakh with a loan at 9% annual interest paying it back with approx. 20K per month payment over 5 years, you would end up paying a total of around 14.5 lakhs to the bank!

We need to understand that when we buy something with borrowed money, we are essentially agreeing to pay a lot more for that thing than its current cost!

While borrowing for buying homes/apartments (which is usually such a large sum that most people need to turn to loans), one should try to save at least 20–30% for down payment. This will help keep the EMIs low.

We should steer clear of high interest loans like credit card loans that have absurdly high rates of interest if the balances are not paid back in full each month. If you do have outstanding loans, start to pay them back starting from highest interest rates ones first.

Being debt (loan) free allows for a worry-free life style without the monthly EMI haunting us every waking moment. It also allows us to save more and invest towards things that matter more to us!

Now we can move on to understanding the basics of Investing and common investments.

5. Investing

Investments come in a wide variety of choices. Think of these choices as being part of a spectrum that has Low risk and low but guaranteed return investments at one end (think FDs, savings accounts, government bonds) vs High Risk and high but not guaranteed returns at other (think highly speculative stocks, IPOs, risky corporate bonds).

The most important reason to start as early as possible with Investing is the tremendous power of “compounding” that grows exponentially with time! To visualize this let us take an example. Let’s say you start investing at age 25 and invest 10,000 each month for next 20 years and then retire at age 60. Alternatively, let’s say you start at age 35 and contribute same 10,000 for 20 years and then retire at same age of 60. Who do you think will have a larger pool at retirement? Can you guess by how much?

Let us assume return on investment is 10% per year for both.

If you had started at 25, you would have 3,17,20,720. But if you start at 35, you would have just 1,22,29,711. See the difference compounding can make over time! Despite contributing the same amount of money (24,00,000) the results are drastically different if you start just a few years earlier! Also note that at retirement, most of the 3.17 crores that your 24 lakh turned into is “growth” (over 90%)! Compounding over time is the biggest superpower any investor has for accumulating substantial wealth! You can use any of the online SIP calculators to play with these numbers around different scenarios!

Before we get into the details of various investment options available, let me first tell you a story about stocks and bonds!

Naisha (we have met her earlier!) wants to quit her job and start a business of her own. It would be a company focused on providing cyber security training to various businesses and institutions. She has saved some money that will help her cover some expenses, but she needs more money to get established and hire more staff. She has basically two choices.

One is to borrow the money from family/friends or a bank. Other choice is to “sell” a portion of ownership of her company to friend, family member or any other interested buyer. Then the buyer will have ownership over that fraction of her company’s all future earnings. She can also do both of these things and raise money both ways. Lenders in this case will have first claim to the money she makes to pay off interest and loaned amount, equity owner will get his portion of what is left after paying off all creditors. (that is why we call equity ownership as “residual” claim on the assets of a company)

If she borrows money, she must pay it back with agreed rate of interest. From the perspective of the investors (providers of money), ownership stake (stock) is riskier than the loan to her business (bond). Hence an investor will only be willing to make an equity investment if he/she gets a higher rate of return than the bond (to justify taking higher risk).

These two basic choices that Naisha had for her company represent the two fundamental types of investments that we can make — equities and bonds!

a. Equities and Mutual Funds

One of the greatest feats of modern finance (modern portfolio theory in particular) has been the idea of looking at and evaluating all our investments as a group rather than in isolation separately. Expected risk and expected return are measured at the “portfolio” level and one tries to maximize the return given the level of risk he/she is comfortable taking. This all sounds great in theory, what does it really mean for me?

Each stock in isolation is “extremely” risky. One can easily lose “all” the money invested in that stock since some companies routinely go out of business. But a group of companies is unlikely to go bankrupt at the same time. So, investors try to “protect” themselves by investing into “groups” of stocks that are diversified in various sectors of the economy.

Since it is hard (and time consuming) to pick a diversified group of stocks, most people elect to invest via mutual funds that are essentially groups of stocks sold as a single fund (and can be bought/sold daily).

Mutual fund charge fees of course (called management fees) and one must be mindful of these fees when selecting funds. Since these fees are deducted from the fund value directly (as against being paid separately) a lot of investors seem to be unaware of the level of fees they are paying. One can easily find the annual fees in the fund prospectus (they are usually in the range of 0.1% to 2.0% of your investment each year).

There is a mind-boggling variety of funds on offer, and one must be careful to select these. One should also avoid sales charges (called fund loads) and buy funds directly online.

A simpler type of funds on offer are “indexed” mutual funds that charge very low fees and simply buy all the stocks that make up an index (for example nifty 100 or nifty 500). I strongly argue for owning these funds rather than funds that actively pick stocks to buy and are expensive. One in this case would get the return that the index will provide. (There is a big debate on whether paying more fees and actively picking stocks is better than buying all public stocks that make up an index, but I would not go into that debate right now.)

b. FDs and Bonds

A problem with stocks (even groups of stocks) is that they can go up and down in value based on market conditions, thereby making your portfolio suddenly lose a lot of value (i.e. they are volatile).

To protect against this volatility, investors add some risk free (or close to risk-free) securities to their portfolio. (example FDs, government bonds or highly rated large company bonds) These tend to steady the ship and give some protection from sudden swings.

Usually the younger you are, the longer is your investment horizon (the period for which you do not need to withdraw the money) and hence you can invest more in the stocks and less in the bonds. As one grows older, it is considered prudent to shift towards bonds and towards less risky investments. A general rule of thumb is to own your age in bonds, meaning that someone who is 30 years old should have 30% invested in bonds). When the same person is 50 years old, he should be 50% invested into bonds and rest in stocks and other forms of investments.

Of course, these are only general rules of thumb and people can deviate from these for all sorts of personal reasons and sometimes tax considerations.

c. Real Estate

Investments into buying physical property in form of land, residential property or commercial property is also a popular form of investment in India.

Although people seem to believe that real estate investments are sure shot way of doubling or even tripling the money in a few years, the reality is very different.

Residential real estate returns in Top 7 cities in India have failed to beat even inflation (annual 6% for last 15 years) in last 15 year period (2003 to 2018) return a paltry annual return of 4%. In comparison large stock mutual funds returned approximately 15% annually on average in the same period, EPF/PPF returned around 8.5% annually on average. Gold averaged an annual return of 11.7% in the same period.

Most people need to take loans to buy a home or most other types of real estate. This further complicates the ability to determine the true “return” on the investment since one must pay the interest to bank while saving the monthly rent. One should also include the Stamp duty, taxes, maintenance, repairs and home insurance in determining a true rate of return on real estate.

d. Gold

Indians have a special fascination with investing into gold. Gold does seem to be a good inflation hedge and tends to do well when most financial investments are not doing well. Long-term return generation is not promising for gold (when compared against stocks over a large period), but it may offer some diversification and hedging against the periods of financial turmoil. But since it is not a productive asset, requires safekeeping/insurance it is probably not a good idea to be heavily invested in it. Warren Buffett also seems to hate investing in gold.

Pay attention to the “Cost” of Investing (fees)

Most investments incur some sort of investing fees that can be direct or indirect. Direct fees are more evident for example trading fee charged by your demat account provider, account opening fee, annual maintenance fee, stamp duty and broker fees for real estate, GST of 3% for gold purchases etc. Since these fees are paid directly, these are quite easy to spot and account for while evaluating investments.

But the indirect fees such as those charged by mutual funds are harder to measure and understand. Mutual funds directly deduct fees from the funds’ net assets, so for example if you invest 20,00,000 INR in a mutual fund that has an expense ratio of 2%, it means that it will charge 2% of your investment every year as fees. So, 2% of 20,00,000 is 40,000 INR which will be your annual fee deducted directly from your invested value. As the fund increases in value, the absolute fees amount you will pay will also increase, for example if fund grows to 30,00,000 in a few years, you would then be paying 60,000 in fees per year!

What Long term returns to expect (and how to spot too good to be true returns)

All of us would sometimes come across investment opportunities through newspaper advertisements, our friends/relatives, colleagues or via unsolicited emails etc. Most of these seem to make promises of “guaranteed” return of a seemingly high rate! We should be very skeptical of any such guaranteed high return scheme. High return investments are by definition very risky (no borrower would willingly want to pay out a higher return if he can finance at a lower rate). “Guarantees” do not mean anything unless the entity making the guarantee is extremely credit-worthy. Also, creditworthiness itself can change with time.

I have seen people subscribing to bonds of debt-ridden real estate companies (promising returns of 15% and above) to whom no bank is willing to lend! We should not be chasing just the high rate of return if there is a good probability that we may lose the entire capital. Corporate bonds are risky and ones that are offering returns approaching long term stock market returns almost always will have a high risk of default.

The right way to think about the risky return rates is to start from risk free rates. Anything that has a government guarantee is deemed to be risk-free.

• Risk Free rates — EPF return 2018–8.65%, PPF return 2018/2019–8% (Amounts in EPF/PPF are capped so only a certain amount can be invested each year)
• FDs — (6–8% depending on duration and bank)
• Risky Investment “Expected” returns: Since right now the risk-free rate in India is in 6–8% range based on above available investment options, one would only make a risky investment if he/she expects a rate higher than these rates.

Since there is no easy (or even hard!) way to predict future returns on risky investments, past history is the only realistic guide we have. Past returns on Indian stock market proxy, SENSEX has been (from the available period of 1979–2019) 17% annually (total return) which is the highest return given by any asset class in India. Gold in the same period gave 10% annually (rupee return), Bank FD around 9%. Even though the percentages do not seem different, stock market return in long run would have a dramatic impact on wealth due to compounding over time.

10,000 INR invested in 1979 would have turned into at the end of 2018:

• 2,68,114 in FDs
• 4,08,474 in Gold
• 45,28,568 in SENSEX stocks!!

So, the annual return rate from SENSEX over this period should set a reasonable upper limit on our expectations from any risky investment. Anything above this rate is not to be “expected” from our investments, and even this rate is only achievable over the “long-run” since stock markets are volatile and may lose value over a few years.

A note about periodic stock market crashes!

Stock market crashes happen every few years and no one can predict when they will happen or what will trigger them. History tells us that in the long term, stock markets generate amazing risk adjusted returns over-all.

We should never panic sell in these down markets. Markets rebound after each crash and if we have a long investment horizon, there is no reason to worry about these downswings that create opportunities to invest even more at lower valuations! These downswings trigger “fear” in us, causing reckless decisions like selling in falling markets and freezing our regular investments, thereby deviating from our investment plans. We should never give in to these emotional reactions and the high-pitched shrieks of news anchors announcing doom. Markets tend to return to health once the crisis passes.

6. Creating a portfolio

Knowing all this, how should one go about designing a portfolio suited to himself/herself? The key principle is to keep things simple and having the discipline to stick to that strategy over very long periods of time.

For someone 25 years old, following steps are all that is needed to put this in action:

1. Set aside some savings in a high yielding savings account. (at least 3 months’ salary)
2. Maximize PPF contributions to fully utilize tax benefit under 80C.
3. Examine how much more can you realistically invest. Let’s say you have 20,000 more to invest each month. Since you already have fixed income assets in your EPF/PPF, there is no need to invest more in FDs, bonds (except sometimes to re-balance your portfolio, since you can’t change allocations inside EPF/PPF). The remaining 20,000 can be invested into an index tracking mutual fund that is very low cost (like Nifty 50 or Nifty 100) via a low fee demat account .
4. Review once a year and re-balance if necessary. (talking about re-balancing requires another article, but if you are just starting you have some time before you need to think about re-balancing!)
5. That’s it! You are setup! Just keep investing every month regardless of the market going up or down. Trying to time the market is a loser’s game. Over long periods of time, stock markets always return positive returns greater than bonds. (other wise these markets would not exist and everyone would just buy FDs and bonds)

A note on NPS (National pension System):

This is a new pension system announced by Government of India that is also beneficial from tax point of view and should be looked at as an investing option. It allows tax deduction up to Rs 2 lakh annually with rules governing how much you or your employer can contribute. Additional tax deduction of 50,000 is available under section 80 CCD (1B) that is not included in Section 80C. Withdrawals are allowed after one turns 60 and there are options around how and with which fund managers one can invest with. There is also a mandatory annuity provision for 40% of the corpus from an approved insurance firm. I recommend you to read more about NPS and how it works and what restrictions apply before registering for it. Also, since the rules on these schemes are updated frequently, it is best to check the latest rules.

7. Becoming conscious spenders

A major problem for anyone trying to save and invest is that his/her monthly expenses leave little or nothing to be invested! We have to think a little differently to be able to tackle this. Most people think of savings as what is “left” after they have spent all that they wanted to spend on. This will almost always never work! Savings are what you consciously “choose” to save as soon as you get paid, and then you budget the expenses from what is “left” after savings. We should try to save at least 20% of our take home pay!

The way you budget is to look at the most important monthly recurring expenses and then consciously decide what you must spend on them and also check if they are even necessary. The biggest expense we have is mostly “rent”. We should not be paying more than 30% of our take home pay on rent as a rule of thumb!

Other recurring expenses are electricity, fuel, groceries, internet, domestic help, eating out, drinks, TV, water bill, newspaper etc. All of these must be carefully budgeted and reduced wherever feasible. There should also be some buffer for things like medical emergencies, travel and any other things that you like to do like swimming, gym etc.

If we spend some time looking at all recurring expenses and have an annual budget for most recurring categories (along with some buffer for unplanned expenses), it will reduce a lot of mindless spending we do without even realizing where the money goes! Once we know where we “actually” spend our money, we can re-allocate and stick to the saving and budget goals!

This is not to say that we should not do anything fun and enjoy our lives. We should, of course! What I am arguing is that the quality of your life will be better if you understand and manage your expenses well. It will help you cut down expenses that do not bring you much joy and help save for the larger and more meaningful things you can do when you are able to save substantial sums. You may also have long term goals for yourself that will become a lot easier to achieve as you start saving, and our dear friend “compounding” will keep pitching in more and more over time!

8. A word about purchasing insurances

Indians have traditionally combined the insurance and investment purchases, buying out LIC policies that act as both. But these policies are generally more expensive than buying a term life insurance and making investments separately. This also gives you more flexibility in your choices of investments. LIC investments are restricted in their equity exposure as well, which make them sub-optimal for most young investors with long investment horizons.

We in general need at least a medical insurance and a term insurance in case we have any dependents, and both these should be bought as pure insurance products from reputable providers. Other insurances like auto and home insurance can also be easily purchased by choosing among many providers.

Another obvious but helpful recommendation is to always buy insurance products online (there are several online portals that do an excellent job of comparing all available policies) without a salesperson in between. This will always get you the best rates (and save you the commission) and usually the best available and highly rated policies.

9. Finally, wealth as the enabler of good!

I know it has been a long way from the top to bottom of this article, but if you have stuck with me so far, here is the last point — that to me marks the philosophical underpinning of the question, “Why bother building wealth anyway?”

Some of us have the irrational idea of wealth as a corrupting and evil influence! This is mostly the fault of movies, media and TV. But the reality is that wealth has great potential to enable our true freedom! When we do not have to worry about the next paycheck and are financially self-sufficient, we are able to think more clearly about whether we truly enjoy what we are doing or is salary the only motive for doing our job! It also allows us to be more creative, since feeling free and independent is known to foster creativity.

Most causes in life require a large set of resources to accomplish and wealth provides a lot of leeway and flexibility to contribute to the causes you care about. We all complain about the crippling air pollution in our cities (Delhi’s pollution levels are notorious worldwide!), but how many of us have the ability to contribute to green technology research or to fund a promising green energy startup firm. We all talk about the deep inequities within Indian society, but how many of us are able to do something about the plight of a homeless girl child living on Delhi streets in winter?

Building wealth, little by little gets us that much closer to being able to rise a little above the rat race of living paycheck to paycheck and think about working on problems larger than ourselves. The satisfaction of leaving a positive impact on the lives of others and enjoying every moment of our life doing the things we love is indeed priceless and a goal worth shooting for!