Application of the Extended Money Equation

In the last post we had defined the Extended Money Equation as follows:-

IS = AI + PI – RME – DME – RAE – DAE – IRE

Let us now look at it in some details in order to understand how we can use it to effectively to manage and control our financial life. We will be using the same analogy of the storage tank and the pipes that was introduced in the last post. To begin with let us look at the inflow part which are essentially Active income and Passive income.

Any income that is derived from an activity such as a job, profession or business is part of AI. Many of us have only one source of AI like salary but it is clearly possible to have multiple sources. For example a Government employee who also does some trading in stocks will clearly have 2 sources of AI. Passive income on the other hand, is income generated from assets or earlier financial investments. The definitive criteria for PI is that it is in an auto mode and we do not have to engage with it in an active way. Examples of PI are Rent of your property that you get, dividends from stocks and MF etc.

What should be our strategy on the income part then? Well, to begin with it will be good to have both AI and PI, but that may not be possible at the start of your career. Also multiple sources of income will boost our AI and that can only be a good thing. As time goes by, we wll start to create financial and real assets which will help us to get the PI stream started. As you tend to wind down towards retirement the PI part will be more and needs to be at a level that you are able to take care of all expenses from it. If that is not so, then the only option is to continue earning AI and/or reduce expenses to match PI.

Let us now look at the Expense part. In the equation RME and RAE will be pretty much defined for an individual and the scope of reduction there will be limited. DME and DAE can be controlled much better, but one needs to remember that activities funded through these are really the ones that enable us to add value in our lives. As long as we are able to fund our goals by having the right kind of IS, I would not suggest that we clamp down on it. If however, the future goals are not being funded then there is really no way but to dampen these expenses, till we get an income boost from AI or PI.

Finally let me come to IRE which is Indulgence related. If your investments as per your goal timeline are not being met currently then you do not have the luxury of indulgences. Spend on this only after you have funded your goals fully.

With this understanding in place you can check regularly whether you are meeting your IS target or not and then take appropriate measures to see that you are getting back on track in case of deviations. The next step will be to get down to making a financial plan that will help meet your goals.

Let me know if you are able to use this equationto understand your financial life better.

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