The 10 commandments that you need to follow for good financial health

The most fundamental law of finance is that there is no such thing as a free lunch. Hence, there is no predictable way to become rich. But there is a predictable way to avoid becoming poor and it includes the following 10 commandments.

Diversify: The most important form of diversification is between asset classes. Do not believe the myth that equity is safe in the long term and do not put more than 50% of your net worth in equity. Some experts suggest a more aggressive allocation depending on risk appetite and time horizon, but my experience with clients time and again has confirmed an inability of people to handle an equity allocation beyond 50% when there are market crashes, regardless of the time horizon and risk appetite.

Minimize investment costs: Investment fees of 1% per annum eat up a total of 26% of your investment over 30 years. The straightforward way to minimize investment fees is to use index funds and direct plans, which charge zero commission.

Minimize reckless mistakes: We will all make mistakes in investing, but we should try to minimize reckless mistakes. In tennis, this is called an unforced error. An example of such an unforced error is holding more than 20% of your net worth in listed shares of your employer.

Do not chase the mirage of alpha: Rationality dictates that we use index funds instead of active mutual funds that claim to deliver alpha or outperformance over the index. Further, don’t use smart-beta or factor funds that pretend to be ‘passive’ but are actually ‘active’, e.g. momentum and low-volatility funds. They do not work and neither does market-timing/technical analysis.

Do not use complex products: Complex products go beyond your mind’s ability to figure out the catch. Accordingly, individuals should not invest in alternative investment funds such as long-short funds. For the same reasons, do not use products that combine insurance and investing, e.g. Ulips. The only exception is that some retired people may benefit from a life annuity without return of principal if they can avoid commissions on it.

Do not retire too early: Do not use the so-called ‘4% rule’ which says that a corpus that is 25 times your annual expenses will last for 30 years. And do not believe the claim that the ‘4% rule’ is applicable to fully retiring at the age of 50, i.e. that a corpus that is 25 times your annual expenses will last for 40 years. Instead, if you are 60 years old and would like to retire, then you should have savings equal to at least 30 years of expenses. Similarly, if you are 50 years old and would like to retire, then you should have savings equal to at least 40 years of expenses.

Save half of your post-tax salary: Saving 30 years of expenses by the age of 60 will typically require you to save half of your lifetime post-tax salary. If you saved less in some years, you may have to save more in other years. This will hurt your current lifestyle and ego. But that is better than dying poor.

Do not completely outsource personal finance to anyone: You should not completely outsource personal finance to anyone. But you may partially outsource it to a Sebi-registered investment adviser or your spouse. If you partially outsource it to an investment adviser, then you should try to minimize conflict of interest. But do not completely outsource it even to an investment adviser because you cannot completely eliminate conflict of interest. And you should not completely outsource it even to your spouse. This is because it’s possible that your spouse is not as frugal as you are or your spouse may be far less knowledgeable about investing than you think they are.

Learn about personal finance: You have to learn a significant amount about personal finance even to figure out who you can partially outsource it to. Do not read blindly. I find that many books and articles about personal finance are completely wrong. So, one should be sceptical about what one reads and the incentives of the writer. If the claim in the article violates the law of no free lunch, then it is guaranteed to be wrong.

Teach your family about personal finance: If necessary, teach your spouse about the basics of personal finance and/or how they should get financial advice. Finally, teach your children about personal finance from a very young age.

Success comes from focusing on your career/business, being frugal and being cautious in your investments.

Avinash Luthria is a Sebi-registered investment adviser and advice-only financial planner at Fiduciaries.in.