Tuesday, April 03, 2007

Building An Asset Base Part 1 - On Consumption 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
My last two articles have been rather technical and I apologise for the heavy reading. Here I take a stab at personal finance and discuss an issue that should be interesting for most: the building of an asset base, or more specifically, cash base.

The importance of this cannot be overemphasised for investors/traders. For the majority (like me) not born with a silver spoon in the mouth, we start our market journey with limited amount of capital to buy stocks. (Market knowledge, of course, is the other resource we sorely lack initially, but it is another discussion for another day.) Yet, it should be clear to most that without a critical mass of equity capital, it is either very difficult or very risky (eg. contra, margin) to build wealth in the stock market.

For example, my opinion (read Full Time Investing/Trading Part 1) is that one should only consider doing full-time investing/trading on his own account if he has at least 500k cash + a steady recurring source of income, OR if he has at least a 1M cash base. Obviously, not many have this kind of money in their beginning years of work.

The most natural starting point is to focus on consumption. The reason is that if we consider our personal cashflow from the perspective of a "personal P&L statement", what happens for many people is that their expenses take up a large proportion of their "revenue" (personal income), such that the "net profit", or remaining money available for savings/investment, is limited. In fact, many live on the edge in this way without a reserve fund for rainy days, and investment notwithstanding, they might not even be able to handle any liquidity needs (eg. medical needs) that surface unexpectedly.

Controlling consumption is the critical step in building one's asset base. Every unnecessary dollar spent is a lost opportunity to compound returns (which ironically suggests that the higher the returns a stock investor can achieve, the more frugal he should be).

My take on consumption is that it may be useful to group consumption expenditure along three distinct avenues: necessary consumption, discretionary consumption, and conspicuous consumption. Description as follows:

Necessary consumption:
Whatever is needed for personal, and for your closest (family etc). Food is necessary consumption, and really.... how much food can one eat? Transport perhaps, and the occasional entertainment/social expenses. Whatever is needed to keep the individual sane.
The greatest error people make are in considering certain expenses as necessary expenditure when they are not, for example they think a car is necessary when public transport suffices. Do you need a car to keep you sane? Another great error, in my opinion, is underspending on necessary expenditure for the people closest to them; it is surprising how people can consider splurging on themselves as "necessary" while omitting the most basic expenditure for their parents eg. monthly housekeeping expenses (especially if they stay under one roof). There should be a re-allocation of expenses from the former to the latter, and one will find that the people around you will reciprocate in unexpected ways.
Necessary consumption is pretty much flat expenditure, whether one's income is $2k or $20k. It probably comes up to $500-1000 monthly. It simply cannot be scrimped upon, but its flat nature means if one cuts down on the other two classes of expenditure, the individual can save substantial amounts as his personal income increases (an equivalent concept would be "operating leverage" for companies).

Discretionary consumption:
This is sort of a halfway-house, not really so necessary but yet as we progress in life, we would like to indulge our interests and fashion etc. Hence girls buy their pretty fashion accessories and guys buy their IT gadgets and gamestations. As one grows more affluent, he may feel a car is affordable especially as he needs to travel more often. And he may be able to service mortgages comfortably enough to consider buying a condominium.
There is nothing "bad" about such expenditure, except that it must be viewed in relative terms to the ability of the individual to make timely payments without compromise to his liquidity, and without making a big dent on his asset base. What distinguishes this class of expenditure from the last one (conspicuous consumption) is that I believe discretionary expenditure should serve some intrinsic need (eg. for entertainment, for hobby, for wellness, for social, for family) but NEVER should it be for vanity (not the "beauty" kind, but the "show off" kind of vanity).
The size of discretionary expenditure is probably a function of personal income, but my feel is that no matter how much utility one might derive from the discretionary consumption, annual discretionary expenditure should not exceed 15-20% of one's personal income (remember the necessary consumption needs), nor should it exceed 5% of one's cash base.

Conspicuous consumption:
It is this last one that will kill you. It costs a lot to look good (as defined above). An example of the difference between conspicuous consumption and discretionary consumption would be to choose to buy a BMW 7-series when a Toyota Camry, say, would suffice. The idea of conspicuous consumption is to outdo the Joneses. If one indulges in sucn expenditure, it will be difficult to build any kind of cash base that can be funnelled into the market. Indeed, a side-effect is that the lack of discipline that defines such propensity to consume also is likely to lead to a tendency to try to get-rich-quick on the markets and to attempt to use the markets as an ATM machine to pay for one's expenditure ..... both big no-nos in risk management.
One should only conspicuously consume if he has assets of $10M or above. This is more of a mental anchor rather than through some meticulous calculations of mine. Until then, a siege mentality should be the operational mode, and (current) asset accumulation, rather than dissipation, should be the priority.

If we follow such consumption rules, then as personal income increases over the years, discretionary consumption takes away a fixed proportion (equivalent to "variable costs") while necessary consumption forms a flat sum (equivalent to "fixed costs") but the amount left for investment will increase exponentially. Compound that by typical annual investment returns of 10-15% (some might call this estimate conservative nowadays .... an MP claimed recently that the CPF Board should be able to achieve 10% returns on CPF with little risk), plus extra returns due to improved market knowledge/experience of the investor/trader over the years, and the ascent to a sizeable stake could be quite rapid indeed.




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