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Most people mistakenly use words like high income and wealth interchangeably.
High income typically translates into enhanced capacity to meet present needs like paying higher rent, car or home loan EMI, premium brands in groceries, and services like gyms. Whereas wealth is created with investments that can be converted into income in the future on their maturity or sale.
In early work life, salary is typically the only source of income. Over time, with investments, other income sources arise like rental income from property and capital gains from equities, mutual funds, real estate, and gold; interest and dividends. To create ample wealth, you need multiple income sources that can effectively replace salary.
The first step towards building ample wealth is maximising the difference between regular pay and expenses. The resultant savings need to be regularly invested in different investment options. Your wealth is your net worth or the value of your future income-bearing investments or assets after adjusting for obligations or liabilities like outstanding loans. Therefore, high present income is no guarantee of high future income. Everybody needs to make their money grow to be wealthy. In this background, it helps to know about common impediments to wealth creation and how to avoid them.
With the exception of a few with high income, early in financial life, the gap between income and expense is typically narrow. A convenient way to maintain investment discipline is to first invest when the salary is credited to the salary account and thereafter, meet expenses. Here, investment in a mutual fund through a Systematic Investment Plan (SIP) is helpful. An SIP investment involves regular investment of a pre-decided amount. You also need a budget to allocate the remaining part of the pay to different essential and discretionary expense heads.
Regardless of income level, repayment of typically high-interest rate, consumption loans like personal loans and loans on credit cards for purposes like gadget buys is a significant financial burden and can impact regular investments. Their interest rates are higher than other loan categories like home loans as there are no assets required to serve as collateral. Repayment of such loans needs to be restricted to 10-15% of take-home pay.
Tax-efficient investments can make a big difference to the wealth created. Investments can get taxed at three points. First, at the time of investment. Second, on returns such as interest or coupon payments and dividends. Third, tax on capital gains on exit or liquidation like that for a mutual fund investment or maturity proceeds.
Since wealth creation involves minimising tax outgo with tax planning, one needs investments with tax deduction on investment, besides for returns and on exit and maturity. For instance, ELSS from mutual funds, with ELSS full form being Equity Linked Savings Scheme, provides an annual tax deduction of contribution of Rs 1.5 lakh under Section 80C in the year of investment.
The other plank of the approach is seeking investments where taxation is deferred till exit or maturity. This allows investments to grow over time, substantially cushioning the impact of tax.
In the case of capital gains, the tax rate may be lower as is the case for equity mutual fund taxation. Capital gains from equity mutual fund investments of more than one year are treated as long-term capital gains. Such capital gains till Rs 1.25 lakh per annum are tax-exempt. Amounts higher than the limit need to pay long-term capital gains tax of 12.5%. This is beneficial for those in the highest 30% tax slab.
Wealth creation is also influenced by the choice of asset classes of investments like equity and debt, besides their proportion. Experts call the asset mix as asset allocation. Research studies have shown that as much as 90% of variation in returns in the portfolio of investments can be explained by the choice of asset classes.*
Long-term wealth creation requires investments in high-risk options with the potential for higher rewards in the long term. Ideal candidates for such investments are equities, indirect investments, or mutual funds like an equity mutual fund scheme, equity-oriented hybrid funds such as balanced advantage funds. Such investments typically experience market turbulence in the short term but tend to deliver comparatively higher returns in the long term, helping money grow faster than inflation. This helps negate the corrosive effects on the buying power of money. Studies have shown that equities grow faster in the long term i.e., 10 and 15 years, compared to alternatives such as debt investments like fixed deposits.**
Wealth accumulation requires long-term returns from the mix of investments or portfolio to be consistently high. Let us illustrate the point with an example of two friends, Rohit and Virat, who invest Rs 10,000 each across investments. Rohit’s portfolio grows by 30% in the first year, declines by 20% in the second, and again grows by 20% in the third. Virat gets a constant annual return of 10% in the three years. After 3 years, Rohit’s portfolio is worth Rs 12,480, but 6.23% lower than Virat’s is Rs 13,310. While both get a 10% simple average annual return, Virat benefits more from the compounded growth with Compound Annual Growth Rate (CAGR) of 10% for him compared to 7.66% for Rohit. To achieve consistently high growth in the long term, mutual fund investors can seek the help of qualified mutual fund advisors.
Inherent behavioural biases can impede wealth creation as investors take decisions based on their emotions and biases, not data and facts. Common biases include emulating decisions of others without considering facts and individual needs, unrealistic expectations of returns, and taking decisions unduly influenced by current market conditions. Biases typically lead to erroneous decisions like premature exits and assuming elevated risks from excessive investments in one investment category.
To sum up, for anyone to be wealthy, money needs to be put to work. Therefore, your friend’s fatter pay packet doesn’t necessarily make him wealthy.
*https://blogs.cfainstitute.org/investor/2012/02/16/setting-the-record-straight-on-asset- allocation/
**https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3959885
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The above is only for understanding purpose and shouldn’t be construed as investment advice provided by the AMC. Consult your financial/tax advisor before taking investment decisions. The % of return, if any, mentioned in this article will depend upon various factors including the tenure of investment, type of scheme, prevailing market conditions, view of Fund Manager on the market etc.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.