Setting your frame of reference right - Part-2

A few days ago a post appeared in my facebook feed in which a friend of mine was asking for investment advice. I was thinking, is he gone mad? How can a sane person can ask for investment advice to whoever sees his Facebook posts? This incidence inspired me to write this second part of my blog post.

In the first part of Setting your frame of reference right, we discussed about how to treat our expenses in a proper perspective.(just like a map.) Now in this part we will discuss about how to look at our investments in proper perspective.

In the last part we saw how a wrong frame of reference can land us into trouble, just like a faulty map (remember those instances when we are finding a place by using Google maps, and because of bad reception our location is shown at wrong point leading us to a wrong way.). We also learnt, how can we compare our expenses to our earnings, here also we are going to do the same thing, that is compare our earnings with our investments.

A simple reference point we can set is how much I earn in a particular time? That is if I am earning Rs. 1000 per 10 hour work day then I am earning Rs. 100 per hour. Then I can think like if I am investing Rs.1000 in one investment which will give me Rs.100 back every year for the rest of my life, then I will have to work 1 hour less every year.

Suppose after cutting for holidays, leaves, vacations etc., you work around 250 days a year, then you must be earning Rs.250,000 per year. Also imagine that you are saving 50% of this income, that is you are saving and investing Rs.125,000 which will give you Rs. 12,500 every year which is twelve and a half days of work.

If you reinvest this passive income from investment and 50% of your job income for 12 years at 10% return on investment, then your passive income for the 13 th year will be Rs.267,000, that is your passive income will exceed your salary. At the same time your investment amount will be Rs.2,673,000. What do you say about it?

Early retirement huh?? ;-) or

FIRE- Financial Independance Retire Early??

I know this calculation is pretty simple, I have not included the inflation rate in this calculation but your job income is also going to increase along with the inflation.

The whole point of this blog post is to provide a proper frame of reference. I am not providing any investment advice. You have to decide it for yourself, no-one else can know your financial condition better than you. And now a days there are pretty easy and cheap investment solutions out there. Making investments has never been so easy. You can make investments by just touching your smart phone screen a couple of times. If your head spins with a thought of how to research stock market, commodities like gold, silver, copper, crude oil, bonds, IPOs, debentures etc., there are mutual funds which can do just that for you, then there are low cost index fund etc.

You just have to stop making excuses, take the responsibility of your finances, think for yourself and start moving.

That's it for today folks.

Have a nice day...

Sumit,

The POWER is when,
You use ODDS,
To get EVEN.

Setting your frame of reference right..

This article is inspired by a friend of mine, who earns a lot, but still don't have a clue why he can't save anything.. I know many people, who are in the same condition.

I suggested him to keep a log of every expense he is doing however minor or obvious it may be. So as to get an idea about where his money is going. Me too did the same when I was in the same situation, and got a headstart in living a frugal, happy, healthy life with lots of investments earning money for me.

Mostly the ideal savings rate is 80% of the income. The more, the better. It has nothing to do with the amount of income. Most people have savings rate of almost 0%.(some also manage to have negative saving rate, that is they spend more than they earn. Obviously they land in to debit trap.)

People give reasons like- my income is small, when it will increase, I will start saving, or this year the expenses are more, once the expenses reduces I will start saving. And savings never happen.

People are not dumb to not understand the benefits of savings and investing. But still they don't save much.

Now why this happens?

The reason lies in our psychology.

Our brains don't have the capacity to judge anything of it's own. We compare anything with something similar, like we judge the temperature of anything with respect to our body temperature, we describe the temperature as hot or cold (with respect to our body temperature), we cannot tell the temperature in degree Celsius or degree Fahrenheit. Or if we see a picture, our brain subconsciously searches for known things and then interprets the unknown things in the picture by comparing with the known things in the picture. For example if we see a picture of a building we can't judge the height of the building (because building can be of any height), but if we see a man standing in the picture then our subconscious knows that a man is generally 5 to 6 feet tall, and we can quickly get an idea about the height of the building with respect to the man.

But what if we have fever? If the man standing in the picture is dwarf (only 3 feet tall)?

Then our judgements will be wrong. If we have fever and our body temperature is 40 degree Celsius instead of 37 degree Celsius. Then we will find things colder by 3 degree Celsius than usual, that's why we feel cold when we catch fever.

Or if the man standing in the picture is only 3 feet tall instead of usual 6 feet tall then we will judge the building twice the size of it's original. But soon we will find other anomalies in our judgement, like we will find something else in the picture which is of normal size and recognize our mistake. That is if we see a Toyota Corolla (a very well known car) in the picture. Then we will quickly think there is something wrong in our judgement, either the car is twice the size of usual (which is quite impossible) or the man may be dwarf (some possibility). So we will come to the conclusion that the man here in the picture is dwarf. And also we will get an idea about the real size of the building.

But if the man in the picture is 5 feet tall instead of 6?

Then there will be a minor error in the judgement of the height of the building. Which will go unnoticed. (around 20% error will go unnoticed.)

Coming back to our topic about savings and expenses. We judge our expenses in a similar way. We compare our expenses with similar expenses of ours or our friends or colleagues. And a 20% increase in the expenses can easily goes unnoticed. And this is how our expenses can easily skyrocket.

But are the reference points right in all above examples?

In engineering drawings it graphical maps or even in the Google maps, a scale is given, that is, this much distance corresponds this much kilometers. This standardized system prevents most of the errors of comprehension.

Now what is the proper reference point to judge our expenses?

I think our expenses must be correlated to our income and not with other expenses, because we just saw how our expenses can skyrocket if we compare with similar expenses but our income has nothing to do with our skyrocketing expenses. It grows with it's own pace.

A simple reference point we can set is how much I earn in a particular time? That is if I am earning Rs. 1000 per 10 hour work day then I am earning Rs. 100 per hour. Then I can think like if I am buying something for Rs. 100 then I would have to work 1 hr. at my job in return. Is the thing I am purchasing worth my spending 1hr at my job?

Suppose I am going to change the engine oil of my bike and the mechanic there is asking for a Rs.100 as service charges for just 15 minutes of work then is it ok for me to spend an hour at my work to change the oil of my motorbike? Of course not... The mechanic is earning Rs.400 an hour, you should rather quit your white collared job and become a mechanic instead. :P

But practically it is very easy to change the engine oil of a motorbike or a car, instead of paying huge service charges and waiting for them to finish the work, you can do it yourself with the satisfaction that I did the right thing, saved money, time, expenses to travel to garage, avoided the headache of taking an appointment, I did it with love and care for my machine, I did it properly.

And trust me the tools and spanners needed are one time expense and you will recover the money in the first time itself. And they mostly last more than a decade.

It is just an example of setting the frame of reference right. It will align your expenses with your income. You have to practice this for 2-3 months and then it will become automatic. Afterwards you will automatically think about any expenses with respect to how much time you have to spend at your job to earn that much money.

So incorporate this habit and start saving your own money. That's the homework..

In the second part of this blog post we will learn about setting the frame of reference right in investing.

See you soon.. Till then have a nice day..

Sumit,

The POWER is when,
You use ODDS,
To get EVEN.