What These Catchphrases Actually Mean

In the world of personal finance there are a number of popular catchphrases that are used. They usually pertain to timeless principles of investing and money management. But our understanding of these catchphrases is usually only superficial. As a result we never really apply them the right way. Therefore in today's post I am going to look at the most popular catchphrases that are used. I will show why our understanding of each of them is wrong. I will then show the right way to understand each one of them.

Be Frugal

Being frugal is often considered to be one of the keys to achieving financial independence. This is undoubtedly true. But being frugal is often confused with being miserly or stingy. This is understandable since both terms bear resemblance to each other. But there is a major difference between them. The difference is in terms of the mindset and implications associated with each. Being miserly or stingy implies abstinence from spending. Someone who is stingy may therefore not spend even when they need to.

In contrast, being frugal implies mindful spending. Someone who is frugal thinks through the pros and cons of each spend before hand. This makes their spending a lot more intentional and meaningful. But there is never complete abstinence from spending. A few more differences between being stingy and frugal are laid out below.

Being frugal therefore means spending only on things that are meaningful and add value. It therefore maximises the satisfaction derived from spending. This allows one to spend without guilt. Achieving financial independence therefore does not demand a bare bones existence and abstinence from spending. It only demands conscious, well planned spending. To understand the concept of frugality in detail, have a look at my earlier article Frugality Decoded.

Follow A Workable Investment Plan

It is constantly propogated that one must follow an investment plan that works for them. But the term 'workable investment plan' is highly subjective. This is because what works for one person may not work for the other. It is therefore hard to rigidly define the term. The right way to approach this would therefore be to write down the guiding principles of our investment plans. The rationale behind each principle may also be mentioned.

This would help serve two purposes. Firstly it would serve as an anchor and reference point when we feel like deviating from the plan. Writing our principles down would also help us uncover gaps in our investment plan. That would in turn help us to constantly refine and improve our plans. This would lead to the creation of a set of principles that we can follow without much effort. A suggestive example of how investment principles should be written down is laid out below.

Build A Simple Portfolio

A simple portfolio is often seen as one with a reasonable number of asset classes (say 2 or 3). But the number of asset classes in a portfolio need not always contribute to how simple it is. Take the case of a portfolio comprising of individual stocks, real estate and cryptocurrencies. Here there are only three asset classes in the portfolio. But this portfolio is far from a simple one.

The stock portfolio will require lot of knowledge and ongoing research to be managed effectively. Real estate is illiquid and indivisible. This makes real estate challenging to manage. Cryptocurrencies are unregulated assets. They are also heavily taxed in India. This means the investor would have no legal recourse if things go wrong. Clearly, the level of risk and effort involved in managing this portfolio is quite high. This is inspite of the fact that it has just 3 asset classes.

This shows that the number of asset classes in a portfolio has little to do with how simple it is. What really matters is the level of effort required to manage the portfolio. A simple portfolio requires little to no effort to manage. It should therefore be built with asset classes that are fit for purpose and easy to manage. Before adding an asset class to our portfolios, we must ask ourselves whether the juice is worth the squeeze.

Keep Costs Low

This is an extremely important tenet of successful investing. Returns from market linked investments only cumulate. But costs associated with market linked investments compound over time. To understand why the case is such, have a look at my earlier article Why CAGR And Market Linked Investments Don't Go Together.

Investment costs cannot be eliminated. They can only be managed. The exercise of keeping costs low is perceived as an endeavour to pinch every possible penny on costs. But there is more to it than that. There are two important principles we must bear in mind to effectively manage costs. We must look to pay only for investments products whose benefits can justify their costs.

Let us understand this with an example. Actively managed mutual funds charge anywhere between 0.5% and 2% per annum in expense ratios. But the overwhelming majority of active funds fail to meet their advertised benefit of beating the market return over the long term. They actually underperform the market. This shows that most active funds cannot justify the kind of expense ratios they demand.

Index funds on the other hand cost between 0.2% and 0.3% per annum in expense ratios. They offer investors the virtual entirety of the market return on offer. They also significantly lower the degree of effort required to manage an equity portfolio. This clearly shows that index funds do more than enough to justify their costs. They therefore earn the right to be considered for our portfolios.

That being said it is important to remember not to nitpick between competent products based on costs. Shifting from actively managed funds to passive index funds saves us anywhere between 0.3% and 1.8% per annum in costs. So it definitely makes sense to do this. But picking an index fund that charges 0.17% per annum over one that charges 0.2% per annum makes no sense at all. Such small savings in costs would not do much to move the needle for us. Such decisions must be avoided. Paying for products with justifiable costs while not nitpicking are the keys to controlling costs.

Stay Invested For The Long Term

This phrase apparently implies picking and holding a set of investments in accordance with a reasonable plan. But there is more to it than that. Successful long term investing requires inactivity, abstinence and emotional control. But achieving the right mix of these three qualities is easier said than done. This is because human are naturally reactionary, impatient and emotional beings.

We therefore cannot completely eliminate the risk of these three qualities impacting our investing. This is why we must make use of the concept of emotional logic. We must tell ourselves that there will be times we are reactionary, impatient and/or overly emotional about our investments. But each time we give in to either of these forces, we risk not achieving our goals. This would allow us to use our emotions to our advantage. It would automatically reduce the likelihood of giving into these forces. The natural consequence of this is that we are more likely to stay invested for the long term. And that in itself would improve our chances of achieving our goals.

Final Thoughts

A superficial understanding of these catchphrases would see them remain just that. But there is a lot to be gained for going beyond the superficial. Going beyond a superficial understanding of these catchphrases requires a lot of maturity. Those who possess it would gain the essence of a set timeless investing principles. And imbibing these principles would help us avoid most mistakes we tend to make with our investments. And that is all we need to ensure positive outcomes with our investments.