When I look back at my investing career, with everything life has thrown at me, I’ve realized that one of the key reason for my investing performance so far has been something so basic – keep extra cash in the bank.

Wanted to buy a new car and had to make the downpayment- No extra cash, sell some stock to fund the downpayment.

Annual vacation  – again sell some stock to generate some cash.

Everytime I promised myself – that I would replenish those stocks asap – reality check – never did so.

I was always fully invested. So whenever there was a need for extra cash, I was always dipping back into my portfolio and unnecessary tinkering with it. I never built up enough cash resources or an emergency fund.

I’ve been through 3 important significant downturns in the equity markets. Dotcom crash – I was to young with very little investible surplus, however subsequent couple of events, both times I was lucky enough and gutsy enough to invest in the markets. I had learnt my lessons well from the great books – be greedy when every one is fearful

While many of stocks in my portfolio turned multibaggers, my inability to hold on to them just because I needed cash – has been the biggest downfall in my investing career so far.

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The Psychology of Money

I recently read this fantastic book by Morgan Housel – “The Psychology of money”. Throughout the book, there was one recurring theme that resounded with me very deeply. That was about ensuring that we don’t interrupt the compounding engine unnecessary and plan for things to go wrong.

I want to read and re-read these few paragraphs from this book -till they create an indelible impression on my mind.

More than I want big returns, I want to be financially unbreakable. And If I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able to stick around long enough for compounding to work wonders.

No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff. Say cash earns 1% and stock return 10% a year. That 9% gap will gnaw at you every day.

But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year – it could be many multiples of that, because preventing one desperate , ill-timed stock sale can do more for your lifetime returns than picking dozens of bi0time winners.

Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time- especially in times of chaos and havoc – will always win.

The Psychology of Money – Morgan Housel

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Second Order Thinking

This is classic – System 2 thinking or Second Order Thinking as Daniel Kahneman noted in his seminal book – “Thinking Fast and Slow”

I have been a victim of First order thinking while not wanting to hold cash – as it gave such minimal returns.

I did not get to the Second order thinking on the lines that holding cash enabled me to meet all of life’s other small and large emergencies and left my equity portfolio untouched and compounding at a healthy pace.

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Lessons learnt

I’m in the process of building a large enough fund, something that I still feel uncomfortable about. Seeing that level of cash sitting idle in my savings bank account still makes me so uneasy. Hence I am writing this post as a reminder as to why I am doing this.

Morgan himself keeps close to 20% of his assets in cash outside the value of his home. He himself admitted that it’s a very high threshold and he doesn’t recommend it to all. I don’t think I may get to 20% ever as I don’t think I’m mentally wired that way although it was be interesting to get close to that and see how it feels.

The follow excerpt from the book tells you Morgan’s reasons for doing so

“We do it because cash is the oxygen of independence, and- more importantly  – we never want to be forced to sell the stocks we own. We want the probability of facing a huge expense and needing to liquidate stocks to cover it to be as close to zero as possible. Perhaps we just have a lower risk tolerance than others.”

The Psychology of Money – Morgan Housel

So what percentage of your assets are in cash? Would love to hear about it in the comments.

Signing off now to add some more fund to the cash account.

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Dave Ramsey was one of the first “personal finance” mentors I came across. I was introduced to him when I first heard one of his interviews on the Success Magazine CD. The 7 baby steps prescribed by Dave was one of the game changers in  my personal financial planning and set me on the path to financial discipline.

Have you had a feeling that you see a huge some of money hitting your account on the first day of month – but midway through the month you have just no clue where all of that money went. I went through something similar. Reckless spending, racking up credit card bills and before I knew I was scampering at the end of the month for some bridge finance to ensure I didn’t miss my home loan emi before the next paycheck got credited.

It was a vicious cycle I was trapped in for a long time. The credit card balances and friendly loans started piling up. All of this – while I still had a decent job with a more than decent paycheck.

Zero Base Budgeting

The first lesson I learnt was called zero based budgeting – figuring out where every single rupee you earned was supposed to go. This one simple exercise makes you super purposeful and allocating the end of use of each and every rupee of your paycheck beforehand – gave you extremely great insight on how you were spending your money.

Dave Ramsey’s 7 Baby Steps

Coupled with this lesson in budgeting – I came across these 7 baby steps from Dave Ramsey. The most fun ( in hindsight I can call it fun) from me was the second step – the debt snowball method. Just this one step went a very long way in putting my finances back on track.  So here are the 7 steps for your benefit

Baby Step 1: Save $1000 for your starter emergency fund (Read INR 50,000 for desi folks)

Baby Step 2: Pay off all your debt (except) your house using the Debt Snowball method

Baby Step 3: Save 3-6 months of expenses in a full funded Emergency Fund

Baby Step 4: Invest 15% of your Household income for retirement                              

Baby Step 5: Save for your children’s college fund

Baby Step 6: Pay off your home loan early

Baby Step 7: Build wealth and Give

Dave Ramsey’s 7 Baby Steps

Debt Snowball Method

Most of the steps above are simple and self explanatory except perhaps – Step 2 – which warrants some more detail. Dave calls this the Debt Snowball Method. You are required to list all of your debts (except the house) from smallest to largest. The sorting is not according to interest rate/ cost of debt – but rather the size of debt. This is a very important distinction as this is not a mathematical exercise but a behavioral one.

Pay minimum payments on all your debt and whatever savings are left over are used to attack the smallest debt on your list. Once you’ve closed that debt, use the additional savings and start attacking the next debt in your list working your way up from smallest to largest. As you work on paying off your smaller debts first, you will have some quick wins which are extremely important from a psychological perspective to keep your motivated. This is actually where the fun begins and it becomes more like a game and you get charged up everytime you are able to make a significant dent.

For most Indians, these debts would generally include, credit card debts, personal loans, car loans and other friendly loans. For the most part – we are lucky not to be saddled with huge educational loans. This would atleast hold good for a vast majority of Indians.

Once you are free from the shackles of these debts- you can move ahead with vigour on your investment and home loan repayment goals.

Being Debt Free ofcouse is the end game and the sooner you get there, the sooner you can breathe the fresh air of financial freedom

Conclusion

Look at where you are today on the ladder of your financial journey. Start with Zero base budgeting and get started with your emergency fund.  Let me know what you think about Dave’s Baby Step plan in the comments.