One of the reasons that people find buying financial products tough is that there is no connect between the product and what it will do. A car gets you around the city. A washing machine, well, washes clothes. And a laptop allows me to write this piece.
But what will that mutual fund do for you? Or this insurance policy? Look at the financial products you have in your portfolio and answer this question: What is the role of each of these products in your life? Why did you buy it and what will it do for your financial life? I have been asking this question at my workshops for a while now and the overwhelming lack of an answer and the sheer confusion about financial products and their function in our lives promoted me to design a system that will attempt some answers.
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Called Dhan Chakra—the circle of wealth, the basic concept forms the heart of the book by the same name that I am working on. I found that the Dhan Chakra concept works across income, social, gender, geographical and other divides and has proved to be a good starting point for financial empowerment.
Imagine a box called Income. While the size of the box may vary, the purpose is the same for all of us, we fill it either each month or periodically, with money that we earn as we convert our physical and mental effort into cash.
For most of us reading this newspaper, we fill this box each month with salary, though other small inflows could be interest, profits, dividends, bonus or repayments on loans given. Now imagine an outflow from this box each month. This is the expenses flow or the living cost that allows us to maintain the human capital and keep it going to work the next day, month and year, so that it keeps filling the Income Box with money.
We now have an inflow and an outflow (of course, the outflow will take into account all expenses including taxes and loan repayments). And look carefully at the bottom and you see some notes and coins left over. Those are your savings, or the excess of the result of the human effort over what it needs to sustain it.
This can be spent as well on lifestyle and other consumption. Why save? But we do instinctively tend to hoard. This instinct comes from the knowledge that human capital has an economic lifespan that is shorter than the biological one, or that we will stop working many years before we die.
We may have to stop working not because we want to but because the body and mind can’t pull any more (yes, I know, that seems unbelievable today). So we save today mainly with the aim of getting our Income Box filled even at a time when the human capital is unable to go to work to generate money.
Now imagine a box into which all your savings flow. This is your Wealth Box. The aim of saving regularly is to help this Wealth Box get bigger and bigger. It must get so big that when the human capital finishes doing what it can, the income from this Wealth Box will replace the salary income. Of course, along the way, there are other smaller goals such as buying a house, financing the child’s education, but the key goal remains retirement. What happens if the human capital dies midway? Enter life insurance. Its role is to keep the income stream flowing for those who share your Income Box, even if the human capital dies midway.
Typically, write Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, and Kevin X. Zhu in a monograph titled Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, from which I drew parts of this analysis, you need four to seven times your current annual income as life insurance cover to keep the Income Box filled, even if you die midway. They recommend a term insurance plan for the biggest insurance bang for each premium buck.
Of course, those with already large Wealth Boxes (Sachin Tendulkar, Shah Rukh Khan) need no life insurance cover. Look at medical, personal accident, household, car and other asset insurances in the same way. Medical and personal accident covers aim to prevent the use of funds in the Wealth Box to finance an unexpected illness or event that will cost more than what the annual living cost can afford. Household, car and other asset insurances aim to protect the physical manifestations of the conversion of your human capital into material objects. That car cost you a full year’s human capital at work, the diamond set, two months, the mixer and grinder, five days of work.
By paying a small charge and buying these insurances, you prevent having to work all over again to buy these things. The house itself, very interestingly, is something that you have leveraged your human capital into the future to buy today. It is against the steady stream into your Income Box in the next 15 years that will continue to pay the EMI (equated monthly instalment) for the house that you live in today. What if you die? Well, those who share your Income Box will pay, be evicted from the house or you buy an insurance cover. The chief role of insurance is to protect the income stream from the human capital and the assets that it has created. All else is smart sales.
When we convert savings into investments, we begin to fill our Wealth Box with several products. Each product has a certain role in the Wealth Box and seeing that we’re out of space now, why don’t we meet next Wednesday to take this forward?
Monika Halan is a certified financial planner and policy analyst in the area of financial literacy and intermediation.
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