How to save

Set your own financial goals :

This series of articles will provide sound financial advice that stands the test of time on how to protect and grow your wealth in simple language for anyone to understand and reach financial freedom and security.

Banks and finance companies can go bankrupt, stock markets can go up as well as down but the strategies explained in these articles will give you financial literacy to take control of your finances away from institutions.

In the previous article we talked about the secret to financial success by striking a balance between the present and the future and living within our means, thereby generating a positive cash flow to put a little bit away for the future to grow, when you will need the money.

This is easier said than done for many of us, but you can do it if you cultivate some financial (self) discipline and create a road map by defining your financial goals.

Financial goal

You can set your own financial goal, be it to save to buy something or save for retirement. The three essential keys to setting goals are:

Be specific – define what you want to achieve and when. Goals can be short term (a few days, months, or a year) and long term (5, 10, or 25 years).

Be realistic – make certain your goals are attainable. Setting unattainable goals will only lead to disappointment when they are not achieved and giving up.

Write them down – keep records of your goals and mark off key milestones as you achieve them. Writing down goals, reviewing them, and recording your progress can motivate you.

If you are saving for retirement, you can set your goal by considering how much you are currently spending monthly for living, excluding children’s education, etc. and taking an assumption how long you are likely to live after retirement.

For example, if you currently need Rs.10,000 monthly to live and you will live 20 years after retiring at 55 years (Sri Lanka average life expectancy is around 75 years). This means, you need to have 10,000 x 12 x 20, i.e. Rs.2.4 million nest egg ignoring inflation before you retire to maintain your lifestyle.

Now you can do your own math by simply multiplying based on your current spending excluding any that you may not incur when you retire to find out what your nest egg should be before you retire.

For example, if you need Rs.100,000 monthly, the answer is Rs.24 million ignoring inflation. The next challenge would be inflation as we all know a loaf of bread today is not the same that was 20 years ago. Which is why your nest egg needs to generate a real return or not loose it’s purchasing power, which we will discuss later.

Written financial plan

If you are to achieve any goal, you need a written plan or budget for spending your money on paper before you actually spend. When it is written down and monitored on a regular basis you are able to measure your progress against the plan as you go along.

Gaining wealth has more to do with financial self-discipline than with anything else. The first step on the path to financial success is accepting responsibility. You are in control of your financial future, and every choice you make can have an impact.

Having financial discipline allows you to make sure you have money for what’s most important to you. A proper financial plan will have a goal and a process to achieve those goals, while working out the financial requirements needed to achieve them.

Using a program like Quicken allows you to see how much cash income is available to spend, save in the short term and invest for the long term in one place and see how your discipline is helping you reach your saving and investment goals.

List each of your expenses separately. Do not group things such as eating out and groceries together and list them as food. Do not add Mobile, Electricity, and Water together and list them as utilities. If you have to cut expenses, you’ll want to consider each expense individually. The budget should meet your ‘needs’ first, then the ‘wants’ that you can afford. If your income is not enough to cover your expenses, adjust you’re spending by deciding which expenses can be reduced. Now that you know how much you have left over, you can decide how much to pay yourself.

Pay yourself first

‘Paying yourself first’ means saving before you do anything else, i.e. setting aside a portion of your income to save the day you get paid. Regular, consistent savings contributions go a long way towards building a long-term nest egg. Most people wait and only save what’s left over — that’s paying yourself last. In other words, the goal of paying yourself first is to help make sure your future key financial goals are covered.

Making your money work for you

Money works for you by helping you to make more money. The rich get richer by investing their money wisely. When you invest your money in a company or in a bank account, someone is paying you to use that money.

That payment is the return on the investment or the interest rate on the account. When you put money in a fixed deposit you know what they will pay you, when you invest in the stock market, you get dividends and capital gains depending on how well the company uses your money to make itself better.

Your money gives you an ‘income’, like the way you generate an income from your efforts. You can make more money when you and your money work together.

Like you demand extra wages with increasing inflation, you should demand an adequate return or a wage from the borrowers for using your money depending on the risks you have to take.

A small amount invested every month without fail will add up to a lot of money in 30 years. If you smoke three Gold Leaf cigarettes a day, each at Rs.35, it adds up to Rs.38,325 a year. If you saved that Rs. 38,325 every year (assuming the Gold Leaf price does not go up for the next 30 years) and invested Rs. 38,325 every years in a NSB ordinary savings account that pays 4.5% per annum interest for the 30 years (assuming it stays the same for 30 years), it would grow to Rs. 2.4 million by the end of 30 years.

Remember that the higher the return you get from your investments the wealthier you become. For example, instead of earning a return of 4.5%, if your savings can grow at 9% per annum you will have Rs. 5.7 million by the end of 30 years.

The effects of a simple 4.5% difference in the rate of return generated by an investment over a 30-year time horizon would lead to your ultimate wealth being nearly 2½ times greater.

Inflation

The biggest weapons you have to fight inflation are: 1. Compound interest, 2. Length of time you allow your investments to grow 3. The portion of your return that is greater than inflation. In the above example, although, you actually saved Rs.766,500 (38,325 x 20) the balance Rs.1,648,071 was compound interest or interest on interest. You had 30 years for your investments to grow.

Unfortunately, inflation or the general level at which prices for goods and services increase can seriously affect your savings as your purchasing power or vale of the Rupee keeps falling.

The real return is the return you get when inflation is factored in. It gives a better idea of the rate at which your purchasing power is increasing or decreasing. For example, if the nominal interest rate is 4.5% and inflation is 3.1%, the real interest rate is 1.4%.

Investing is, in part, a race against inflation. Unless your returns beat inflation, what you are left with at the end buys you less than it did at the beginning (negative returns). But this assumes your inflation measure accurately reflects changes in the price of goods and services that you buy or want to buy in the future.

The government’s inflation measure is the New Colombo Consumers’ Price Index (CCPI) (Base 2006/07=100), published by Department of Census and Statistics.

The CCPI in the previous 12 months to April 2016 was 3.1%. However, your personal experience of price changes over that time could be very different. CCPI is only an estimate of a basket of food and non-food items consumed by an average household that spent Rs.27,972 a month in 2006/7.

In reality, people spend different amounts on different goods and services, and spending habits can vary therefore, it will not perfectly capture changes to your cost of living.

You can build your own inflation measure for each spending category by using a program such as Quicken when you maintain your own spending over several periods.

Look out for the next article in the series: ‘Investing in Unit Trusts’.

Ravi Abeysuriya is the Group Director and CEO of the Candor Group and can be reached at [email protected]