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Wealth creation. A comfortable life in retirement. Expensive vacations. A good life.
As tempting as these prospects are, many employees find it hard to imagine having it all. Take the case of this gentleman, Ron, whom I recently met in my investor education class.
Ron has a good mix of stocks, sticks to mutual funds, and has done some level of (financial) goal planning. Ron’s argument was that financial plans were easy to do, but many things regularly derailed the plan.
Challenge #1: Expensive health care, little insurance
Ron had a rough few months with a relative who had to undergo emergency brain surgery. His employer’s insurance covered 60% of the damage and he had to pay the rest himself. His emergency fund ran out and he too had to give up some investments. Ron has full medical insurance of Rs 5 lakh which is not enough for complex surgeries.
Rising medical costs can be a barrier to wealth building, especially if you or your loved one is frequently hospitalized. A life-threatening illness can set you years back in your financial planning. As medical inflation in India is over 10%, it is necessary to have medical insurance of at least Rs 10-15 lakh as well as critical illness coverage. It’s the least you should have. It’s not just the hospital bills that you, or Ron in this case, have to worry about. The costs involved are also high, so it is important to have life insurance or health insurance to fall back on in such emergencies.
Having health insurance is not enough. It is also important to have good coverage with the fewest floors and exclusions. Ron mentioned that he never took the outer shell because he was confused with all the information about the different diets. I urged Ron to check Moneycontrol’s health insurance rating.
Challenge #2: Too many loans
Ron is also struggling to save due to the Equivalent Monthly Payments (EMI) that he has to pay. Ron has taken out a second home loan to finance the purchase of an apartment because he is about to take out his first home loan. He estimates that the apartment will bring him 12-15% and that he can still make a profit on a 7.5% loan.
People often fail to understand the impact of loans on total wealth and end up borrowing more.
He supposes that person X and person Y have the same salary, but X has a smaller loan and Y has a larger loan. As can be seen, after 20 years, Y becomes negative due to the compounding of the interest on his loan, while, as in the case of X, the investments accumulate and grow exponentially.
economically free X vs. AND 1710_001
Challenge #3: My investments don’t even outpace inflation
Like other investors, Ron is concerned about rising inflation. A quick check showed an allocation of 10% in mutual funds and the rest in time deposits and insurance. With a 10% equity allocation, it is difficult for the portfolio to outperform inflation.
3 steps to financial independence
Getting your finances in order is not rocket science. But you have to be disciplined. Here are three big steps I recommend to properly prepare your investment portfolio:
Check if the expected weighted average return of your portfolio is greater than 7% per year.
Evaluate each investment and see if it outperforms inflation
If your portfolio can’t beat inflation, change the composition of asset classes. Ron desperately needs to increase the stock allocation in his portfolio based on his financial goals.
There are many factors involved in managing finances and he must be prepared for things that do not go as planned. Borrowing as little as possible, having the right insurance with an extra amount for unexpected situations, and the right mix of products that yield good after-tax, inflation-adjusted returns will certainly go a long way toward easing your path to financial freedom.