As on 2nd October 2022, world markets are anticipating and pricing in the imminent collapse of Credit Suisse. Credit Suisse is a top Global Bank headquartered in Switzerland, with a storied history of 150+ years in investment banking and private wealth management. The markets have been in turmoil of late due to a multitude of crises over the past few years, but such is the nature of the beast. Credit Suisse, however, can blame atrocious business decisions and incompetence in risk management for its predicament. Archegos and Greensill are interesting case studies, but I digress. 

History is littered with corpses of corporations universally believed to be “too big to fail”. The Credit Suisse collapse, if it happens, would just be the latest in an endless line: Barings Bank, LTCM, Enron, Arthur Andersen, Worldcom, Lehman Brothers, AIG, Wirecard, Theranos…. The media has a field day reporting on these collapses with lurid visuals of now-former employees disoriented and in shock, walking out of their now-defunct offices as they suddenly find their lives upturned. 

This got me thinking about consequences for employees caught up in a whirlwind beyond their control. Over the past few decades, corporations have encouraged employees to participate in programs to buy their (listed or unlisted) stock, thus aligning the salaryman with the owners of the company and mitigating moral hazard. These programs can take many forms, Restricted Stock Units, ESOPs, ESPPs, all of them aimed at reducing the cash wages, while inculcating ownership in the employees. This is also a way to ensure the employees have skin in the game as their net worth rises significantly when their company’s stock rises. These programs may also have a vesting schedule, where payout hinges on long-term stock performance rather than short-term quarterly results cycles. 

While these programs achieve the corporate objectives very well, they are also a sweet deal for the employee. With the passage of time, staff accumulate a substantial chunk of their net worth in their employer’s stock and drawing this down could be a key component of their retirement plans. While this works if you are employed in Google from 2010 to 2020, employees of Enron learned a bitter lesson in 2000 with a triple whammy: They were freshly unemployed, their industry did not have suitable roles to absorb this surplus and their net worth eroded to zero if all they had was Enron stock. Rather than a moving scene of a captain willingly going down with the ship, these were galley slaves tied in chains as water surged into their quarters. 

Efficient markets tend to compensate investors for risk taken. For example, someone exposed to small-cap companies is taking on more risk than one investing in a broad-based total-market all-cap index, and could hope for a slightly elevated return over time compared against the total index. The same holds good across other factors (value, quality, momentum, size and volatility). This potential for extra returns is a compensation for taking on extra risk. This however, does not stretch to taking positions and concentrations in specific companies or industries. Uncompensated, or idiosyncratic risk, is your headache and the market is not obliged to heed your wishes. The stock does not know (and does not care) that you own it as it crashes and loses all its value.

If your reward is distributed across a thousand coin tosses, you can be sure of hitting heads around five hundred times. However, if an outsize reward awaited you based on the guess of a single coin toss, you better call it right. Planning for your future, however, should not rely on luck blessing the company you have bet on by circumstance of your employment. It is risky to have an outsize exposure to a single company (or even to a small group of companies). This is doubly applicable for those with a significant investment in their company stock – not only is your net worth tied up with the whims and fancies of your company, it is also the source of your future earnings. Figure out your comfort level threshold and retain company stock up to that level of your net worth. Target to sell vested stock beyond that threshold and immediately purchase diversified broad-market assets such as total world equity indices as soon as the sale amount is credited to your account. There could be tax implications of these trades, so you would need to plan accordingly. 

Parting thought: Always remember that this could be you.

While purchasing life insurance, you may keep the following principles in mind:

1. Insurance is meant to help you fulfil your financial responsibilities even though you are no longer around. Insurance is not meant to be an investment product. Use term insurance to obtain the risk cover you need. Invest the rest of the premium into an actual investment product in line with your investment objectives.
2. The financial markets have a multitude of products for specific requirements: Stocks for wealth creation, Bonds for reducing volatility, Gold as an inflation hedge, International investments to reduce home country/ currency risk, insurance for transferring event risks etc. The flip side is that given these multitude of tools, you could potentially use the wrong tool that doesn’t suit your purpose. The usage of insurance products for investment purposes along with risk cover is one such example. On a yearly basis for these products, the premium you pay is split into a very small risk cover component and a bulk to go into sub-optimal investment products. Neither does this chimera offer enough financial protection in the event of death, nor does it offer investment returns. The only people who gain from this transaction are the agent who gets his commission from your premiums and the insurance company that gets its fees.
3. The policy is required only if there is an income that needs to be substituted. If you do not earn an income, you do not need term insurance. If there’s no financial impact, the premiums paid are pointless. If you are no longer earning, you no longer need to keep the insurance active and could let it lapse by not paying the premium.
4. The policy is required if there are beneficiaries who depend on you financially. If not, there is no point in paying thousands on a yearly basis that could better benefit you better in spending now or investing to spend at a later point in time.
5. There is no point being over-insured. The premium you pay depends on the death benefit, so purchasing excess cover you don’t require is a waste of money that you can better invest elsewhere to benefit your dependents.
6. All other factors being alike, the probability of a 25-year-old dying in a given year is smaller than that of a 60-year-old, which means that the premium required to cover you rises with age. The sooner you purchase the cover, the lower the premium will be. However, you also pay for more years, so it tends to even out over the long run. In an actuarial sense, the insurance company is neutral to your demise if you take the cover at 25 or 60 as the premiums are corresponding to their risk.

The term insurance product is wonderful to transfer the risk of your untimely demise and protect your dependents. How much of a cover is appropriate for you? We will cover that up next.

The brush that Indian professionals have with Insurance products is primarily as an investment vehicle to use the Section 80C deduction while filing taxes. While this provision aims to inculcate long-term saving, investment or protection habits, we should look beyond tax benefits of these products to optimize their utility for us.

The core purpose of Insurance is to provide a backstop to the financial position of the policyholder (or beneficiaries) if any unforeseen circumstance trips up our well-laid plans.

Life insurance, specifically, is meant to provide your financial presence in the unfortunate event of your physical absence due to death. The simplest (and cheapest) insurance policy that fulfils this core purpose is a term insurance. This is a product wherein the buyer purchases protection for a fixed term by paying fixed premiums annually. If the buyer dies during that term, his beneficiaries get a lumpsum death benefit. A whole bunch of us pool our risk to pay out a select few Yamaraja beckons.

Think of this as a bet that you enter into against many others:

1. Premium: All of you contribute a small amount into a communal pot. Since each of you has a different probability of winning (i.e., dying), the amount you pay into the pot may differ and is calculated by the insurer.
2. Death Benefit: A small percentage of those who contributed take away a big portion of the pot if they win.
3. Underwriters: This central counterparty facilitates this betting pool by calculating what each of you have to put into the pot based on your risk profiles, their expenses, commissions, taxes and the profit they have to make to ensure they stay in this business of collecting money in pots.
4. Renewal: If you survive through the year, the pot is now empty and you get to contribute again to stay in next year’s bet.

Alternatively, this is a bet you enter into against the insurer.

1. You bet a small amount that you will die during the year. The death benefit you stand to receive is large enough relative to the premium paid, to make financial sense for you to enter into the contract.
2. The insurer bets a large amount that you won’t die during the year. The premium they collect from you is large enough relative to the death benefit paid out, to make financial sense for the insurer. The insurer should be able to profit with your premiums after paying out the % of claims due during the year, post expenses, commissions and taxes.

In both cases, these are bets you should be happy to lose every year.

Insurance is NOT meant to be an investment product. Products that claim to be both tend to be costly and suboptimal, and you receive neither investment returns nor risk cover. You will be better off using term insurance to obtain the risk cover you need and investing the rest of the premium into an actual investment product in line with your objectives.

Let’s start off with a story.

Ramu is a street hawker who buys items that he can sell after adding a margin. He may choose from two items in wholesale, sunglasses and umbrellas, for the sake of simplicity. If he chooses to sell Umbrellas and the day is sunny, his business wouldn’t do well. However, he would sell out all his stock if it rains instead. Similarly, if he selected sunglasses to sell, he would sell all his stock on a sunny day but close to none on a cloudy day. If instead, Ramu chooses to sell both umbrellas and sunglasses, he can be relatively confident of steady business regardless of whether the day is sunny or cloudy. While it is not likely that he will sell out his stock on any given day, he will also not likely go home empty-handed. A steady such flow of business would be preferable over a roller-coaster of stock-outs on one day and no business the next.

This is diversification, a key concept in finance. A common-sense strategy that one should not put all their eggs in one basket. Typically, our finances tend to be concentrated, unless we take active steps to diversify it.

A few typical examples of concentration are as follows:

1. Your monthly salary makes up almost your entire income
2. Your entire net worth is in your home country (E.g., India)
3. Almost your entire net worth is in real estate, concentrating your net worth to a single locality
4. Almost all your liquid investments are in shares
5. Most of your investments are in a handful of companies

Each concentration is, in fact, a bet that you are taking on. There’s always the possibility that the asset you have bet on grows faster than inflation, and you reap great rewards. However, if the asset underperforms inflation, you stare at a possibility of a much smaller nest egg at the end of your accumulation journey and may face a consequent erosion of your quality of life. It should also be noted that diversification is good when in moderation. There is no benefit of owning thirty Mutual Funds if they are mostly invested in the same underlying companies. There is no benefit of selecting and owning forty shares across the same four industries. For each of the examples above, there are simple actions that can be taken to reduce concentration and enhance diversification:

1. Grow additional streams of active or passive income
2. Invest outside your home country through direct stocks or mutual funds
3. Limit investments in illiquid real estate assets
4. Increase the liquid asset classes invested in beyond equity through Bonds and REITs
5. Diversify the number, size and sectors of shares you have invested in through mutual funds

We will delve into each aspect of the above in the fullness of time. There is still systemic risk that cannot be diversified away, but that’s a story for another day. For now, here’s some additional reading on diversification.

“What can be measured, can be improved.” – Peter Drucker

If you draw a salary, you tend to have a regular credit to your Bank account of roughly the same amount each month. In contrast to this inflow, you face a multitude of expenses that debit your Bank account, the timing and value of which may be uncertain. Consequently, while all of us may know how much we earn at the start of the month, our estimation of what is left over at the end of the month would be fuzzy. What we are even less sure of, is the nature of spending done through the month. While some debits from our Bank account may be building our assets (E.g., Investments in capital markets or payment for a home loan EMI), some others will be consumption related (E.g., groceries purchased or loans repaying depreciating asset purchases). One of the keys to accumulating wealth is to maximize investments and minimize consumption. To distinguish the debits from our account into these two categories, desirable and undesirable, it is essential we track our expenses on a frequent basis.

The primary benefits of tracking expenses are:

1. You gain an understanding of the volume, timing and categories of your money outflows and can therefore optimize or reduce some waste that you can identify on an analysis of your spending categories
2. You shine a light on expenses that are not monthly, such as car service, insurance payments, etc.
3. You can match your inflows and outflows, and arrange your finances to have money waiting when bills fall due
4. You can systematically increase the proportion of your salary that goes into investments once you have arrived at your investment/ savings rate

Traditionally, expenses used to be tracked with spending logs that had to be then tallied up at the end of a month. The advent of technology has enabled us to automate this activity and have a convenient analysis in the palm of our hands at any time of our choosing. There are many apps which track, categorize and summarize our spending for us available for free these days.

I have an Android phone, and one such app I personally use to track my personal finances is Walnut. The app reads SMS messages, remembers past transactions, categorizes transactions and can also provide downloadable excel files of all my expenses for any time period of my choosing. The iPhone version of the app does not have permission to read SMS, so I believe this app is of limited utility for iPhone users.

I would recommend the following considerations at the time of tracking expenses

1. Smartly bucket your spending. Having too few (or too many) categories may mask wastage and prevent you from generating actionable insights to optimize your spend
2. I recommend two categories for your asset accruals as well – Home Loan EMI and Investments. While 100% of your investments goes into building your assets, the home loan EMI amount is split into a principal component and an interest component.
3. You should target that the spending on your asset accruals should total up to at least 50% of your cash inflows. If your investment proportion is currently less than that, it is essential to have a plan to reduce consumption expenses so that you are hitting the 50% mark within a realistic timeframe. I would consider this 50% as a watershed mark, as this roughly means that for every year of working you are accumulating assets that allow you at least one year of free time.

Lastly, this act of tracking expenses would also set forth a virtuous cycle where you constantly seek to optimize your spending and investing to bring the countdown timer to your financial freedom closer to zero.

To optimize the debt payoff journey, it is essential we realize the following aspects:

Interest/Principal Proportion

Interest accrues on the balance outstanding at any point in time. As the balance outstanding at loan start is higher than towards the end of the loan, most of your Equated Monthly Instalment (EMI) at the start of the loan accounts for interest and only a small portion goes into repaying the principal. Over time, as the principal balance reduces, interest accrued on outstanding amount reduces and therefore, a greater amount of the EMI pays off the loan principal. Thus we can note that the loan balance depletes slowly at the start of the loan and gathers pace as time goes on. That makes it in the Bank’s interest to keep the borrower in the first half of the repayment schedule, where the interest payment proportion is high, rather than the second half when less interest is accruing.

Lumpsum Payments

To minimize interest paid during the life of the loan, you should repay lumpsum amounts towards principal as and when you come across additional money. In case of salaried employees, one of the best uses of the annual bonus payout is to throw it at the loan, as this repayment is a guaranteed return of your current EMI rate. The balance outstanding is reduced, bumping up the interest portion of the EMI, while also reducing the interest accruing daily as the balance is smaller.

Stepping up your EMIs

In addition to periodic lumpsum payments, the borrower should also aim to repay the loan faster by stepping up the EMI amounts. Any increment in your salary should also increase your EMI amount by at least the same proportion. This also has the benefit of reducing the cashflow into your account, thereby preventing lifestyle creep.

Never-ending loans

If the amount paid by a borrower on a monthly basis is LESS than the amount of interest accrued on the outstanding amount for that month, the loan is in “Negative amortization”. 100% of the amount paid goes to the interest and the amount of interest in excess of the amount paid is added to the principal outstanding. The loan balance increases and your loan is never repaid. It’s therefore essential to ensure that at a minimum the EMI amount exceeds the interest accrued from day 1 of the loan to prevent the borrower from being ensnared in a debt trap.

Impact of changes in Interest Rates on Loans

The interest rate may be either fixed or floating. Fixed interest rates do not vary over the duration of the loan, while floating rates are reset on a periodic basis (say quarterly) in line with an agreed upon benchmark. In India, Banks currently use the Marginal Cost of Lending Rate (MCLR) to determine the interest rate of the loan. The amortization schedule automatically adjusts the interest and principal component of each repayment to a changed interest rate, so any variation in the interest rate reflects in a change in the end date of the loan – A reduction in the rate reduces the number of pending instalments, while an increase in the rate adds more instalments to the end of the schedule. While the borrower does not feel the impact as the same amount is debited from his account every month, he will be in debt for longer or shorter on the basis of the upward or downward adjustments in the interest rate.

Let’s start off with a basic understanding of how debt is paid off. While the concept is pretty simple, it’s surprising that this is not common knowledge. A clear idea of how debt accrues and is paid off is useful to take control of the debt repayment strategy that works best in your interest.

Amortization is a method to calculate the repayment of a loan over time. From the day you borrow money from a lender, the lender accrues interest on the amount outstanding. A portion of every repayment goes into repaying the accrued interest and the remaining amount of your instalment reduced the principal, or loan amount left to pay back. An amortization schedule is drawn up for a monthly repayment amount at an agreed upon interest rate. This amount is usually a regular monthly amount (Also called as EMI or Equated monthly instalment), so the borrower can plan for arranging the agreed upon amount on a monthly basis.

Amortization schedules are easy to generate on an excel sheet, and we also have many versions online. A basic skeleton of an amortization schedule is as below:

Date	Principal (Month Start)	Annual Interest Rate	EMI	Interest Accrued	Principal Repaid	Principal (Month End)
01-Jan-21	1,00,000	12%	1,500	1,000	500	99,500
01-Feb-21	99,500	12%	1,500	995	505	98,995
01-Mar-21	98,995	12%	1,500	990	510	98,485
01-Apr-21	98,485	12%	1,500	985	515	97,970
01-May-21	97,970	12%	1,500	980	520	97,449
01-Jun-21	97,449	12%	1,500	974	526	96,924
01-Jul-21	96,924	12%	1,500	969	531	96,393
01-Aug-21	96,393	12%	1,500	964	536	95,857
01-Sep-21	95,857	12%	1,500	959	541	95,316
01-Oct-21	95,316	12%	1,500	953	547	94,769
01-Nov-21	94,769	12%	1,500	948	552	94,217
01-Dec-21	94,217	12%	1,500	942	558	93,659
01-Jan-22	93,659	12%	1,500	937	563	93,095
01-Feb-22	93,095	12%	1,500	931	569	92,526
01-Mar-22	92,526	12%	1,500	925	575	91,952
01-Apr-22	91,952	12%	1,500	920	580	91,371
01-May-22	91,371	12%	1,500	914	586	90,785
01-Jun-22	90,785	12%	1,500	908	592	90,193
01-Jul-22	90,193	12%	1,500	902	598	89,595
01-Aug-22	89,595	12%	1,500	896	604	88,990
01-Sep-22	88,990	12%	1,500	890	610	88,380
…
…
…

For floating rate loans, the interest rate changes on a periodic basis (usually quarterly). Consequently, the schedule could incorporate calculations by varying the interest rate for particular months.

Prepayments, in India at least, are applied to the principal outstanding. So, if the borrower approaches his lender to prepay a certain portion of the loan, the amount reduces the principal so the interest accumulating monthly jumps downward.

What can be measured, can be improved. An amortization schedule allows the borrower to project the loan into a series of cash outflows from his account during the years that follow. This enables appropriate planning of the future – examining the impact of changes in interest rate, planning for prepayments and also for increasing the EMI – with an approximate view of how the loan repayment will be modified by factors within and outside the borrower’s control.

What makes us human? I feel that the key differentiating factor between us and the rest of the animal kingdom is our understanding of the concept of time. Specifically, we can project our thoughts to the future and relate to the future version of ourselves. Animals, however, are programmed to live in the present. The concept of the future does not exist for them, at least not in the sense we are able to connect our future selves to our present.

How does this behaviour play into the field of personal finance? It’s through a simple concept of delayed gratification, and has been the subject of a very interesting study by professors at Stanford university.

The setup is as follows: Four year old children are led into a room one by one and given a small reward, in this case a marshmallow. They are then offered two choices: They can eat the marshmallow right then, or if they decide to wait for 15 minutes, they will be rewarded an additional marshmallow. Roughly two out of three children would eat the marshmallow and forego the additional marshmallow. One of the three children managed to last the whole 15 minutes and were rewarded for their wait with the second marshmallow. The children that lasted through the wait did so by distracting themselves (singing songs, falling asleep, licking the marshmallow, playing with their clothing, etc.). In follow-up studies of the same population of children, it was found that the children that were able to delay gratification had better SAT scores, lived healthier lives and were more successful than the children that could not.

Subsequent studies have analysed variants and concluded that the children’s response also depended on their upbringing at home – The poor children tended not to wait because were not sure the promise of two marshmallows will be honoured based on their experiences at home. Inadvertently, this may explain why people in financial crises may not be able to think beyond the immediate future and keep taking decisions that act against their own self interest and keep them poor.

Thus, the ability to exert self-control is key to success. Mapping this to the field of finance, the ability to forego instant gratification and wait out for the delayed (and bigger) reward is a determinant for a secure financial future. If you can resist the urge to buy the latest iPhone the day it comes out and invest the amount into assets that appreciate in value, you will be able to reward your future self with a present that travelled through time. This is all the more important in today’s age of a YOLO (You Only Live Once) philosophy, egged by the constant temptation of advertisements and marketing all around you, and enabled by credit solutions of Zero-interest EMIs and one-click buy solutions that encourage you to spend money you have not earned yet.

PS: There are plenty of entertaining videos of the experiment online, I’m linking a few below:

Joachim de Posada: Don’t eat the marshmellow

Link 2

Link 3

This post may align with those that generally count themselves as middle class. Your family values inculcated the focus on education and a drive to find employment in a good stable job till retirement.

We begin two generations ago. Your grandmother took care of the house, while your grandfather worked for the government in some capacity or the other. His pay was adjusted to inflation over the course of his working life, and when he retired, the government paid an inflation-adjusted pension till the end of his life, and took care of your grandmother till the end of hers. Your grandfather worked one job for forty years, bought the house he resided in with years/decades of savings, and lived a frugal retirement from 60 to 80. The government funded pensions with a defined benefit retirement scheme that guaranteed a level of cash payout every month long after your grandfather stopped working. Your grandfather took out a low-interest loan from the government, for the singular purpose of owning the house he will retire in.

Fast forward a generation, and the private sector has outpaced the government in providing jobs to the Indian employee. Your parents worked in five to ten companies through their lifetime. There is no pension that their employer provides them, but your parents had a portion of their paycheck flowing into defined contribution retirement plans. They also invested into real estate during the course of their working years, and your parents are able to manage a good standard of living thanks to regular income coming in from their provident fund investments, and monthly income from houses rented out by your parents. Your parents focused on paying down their home loans, funding your education and were generally successful in saving more than they spent over their working career. This gives them a cushion for a comfortable retirement post 60.

And now cut to the 2000s. You may expect to change not just jobs, but the pace of change is likely to make your current job redundant within a decade and to continue to have a paycheck, you will need to change your career multiple times through your working life. You are bombarded by thousands of advertisements every day to spend money you have not earned yet. There are promises of easy credit, zero interest EMIs and credit cards, and you find there’s not much left in your account at the end of the month. However, you tell yourself you don’t need to worry as your retirement is forty years away and that everything will sort itself out in the end. The sky-high property prices remove any thought of real estate investing from your mind. Meanwhile, the latest iPhone has just released, and its screen is one inch wider than the previous iteration of the iPhone (which you own). It would be humiliating if your phone is a generation older than that of everyone else in your friends circle. Your Facebook feed is full of photos of your friends enjoying vacations in cool foreign locales. This reminds you it’s time to plan your annual vacation.

The 4% rule of thumb is a handy tool to guide many aspects of financial planning. We will discuss a few of them below:

Size of your target corpus:

Once you have an idea of most of your current annual expenses (recurring as well as one-time), multiply by 25 to determine a target investment corpus. What can be measured can be improved, so the biggest advantage of the 4% rule is that you are able to focus on growing this corpus and accelerating your path to independence.

Date of financial independence:

You can compute an amount you can systematically invest on a monthly basis once you have an idea of your monthly cash flows (salary/ business income inflows and expense outflows). You may assume a conservative growth rate for your investments, and the date the size of your investment corpus exceeds the size of your target corpus is your estimated date of financial independence.

Spend or Invest decisions:

For every significant expense, you can pause before you pull the trigger and make the purchase. If you plan to retire in ten years, the 4 lakh every year that you spend on vacations till then can instead be invested in the market (returning, say, 10%) to allow you to withdraw INR 21,000 every month after ten years for the rest of your life. While that INR 21,000 ten years from now may be worth only 11,865 in today’s rupees considering a 6% inflation, you can make a judgement call whether you would value a ten ten-day holidays higher than a 20,000+ monthly cash flow for the rest of your life.

Fast-tracking your target date:

Having a clear goal enables you to optimize your path. By reducing your significant and/or recurring spends over time, you can advance your target date. If you invest the amount of money you forego spending on, you can estimate how sooner you can be independent. In parallel, if you crimp your spending to a lower amount by targeting your significant and/or recurring spends, the required investment corpus is automatically lower, again bringing forward your retirement date. Once this becomes a habit, you may identify many extraneous spends that were in effect, keeping you in the hamster wheel for longer than you should have been.

Shift from Net income to monthly investment:

We tend to evaluate the size of a purchase by the number of days we would need to work to earn the amount being spent, after tax. But once we shift our focus to the investments we make on a monthly basis, the time horizon gets magnified, providing a truer picture of the cost of the purchase. For the travel example above, if we earn 1 lakh a month after tax and save 30% on a monthly basis, four lakh represents four months of income, but over a year’s worth of foregone investments and consequently the true cost of what you are paying is clearer.

In summary, the 4% rule brings in clarity and a simple long term goal to focus on while you count down your days to financial independence.