Now that you have worked out your timeline and future values of all your goals, you have got a map of your future life both in terms of activities / events and also the corresponding financial needs. What is needed next is to understand the plan of how those financial needs are to be met. We will get to that shortly.
For now though, it is important to understand the money equation that links income, expenses and investment. Well, as readers of financial blogs and articles you must have been hammered relentlessly by the following equation:-
Income = Expenses + Investment or Investment = Income – Expenses or Expenses = Income – Investment
While there is nothing fundamentally wrong with the above equations, they unfortunately do not give us a complete understanding of the dynamics of personal finance that each one of us need to be clear about. If you look back at the post which talked about the dynamics of spending you will understand the need for something better. Over a period of time, I have zeroed in on the Extended money equation that is given below:-
IS = AI + PI – RME – DME – RAE – DAE – IRE
IS : Investing surplus that is available with you, in order to invest for your identified goals.
AI : Active income from your job, profession or business.
PI : Passive income generated from your assets or other past investments.
RME : Regular Monthly Expenditure covering all mandatory expenses that occur every month.
DME : Discretionary Monthly Expenditure.
RAE : Same as RME but for expenditure happening annually
DAE : Same as DME but for expenditure happening annually
IRE : Indulgence Related Expenditure.
Understanding the extended money equation in terms of what it means for you as a person, will change your financial life for the better. Note that while the equation is generic, what constitutes each category is very specific to you as an individual. To give a personal example, my DME has expenses related to buying books and eating out and my RAE has expenses related to travel. In fact travel is so important to me that I do not classify it as discretionary.
Once you understand the expenditure part, you will be in far greater control of your financial life. Let me give the analogy of a storage tank here – water is coming in through some pipes and is taken out through others. Now in the above equation, AI and PI are your incoming pipes. RME, DME, RAE, DAE and IRE are all outgoing pipes. You can have some of the pipes closed but not all.
At the beginning of your career you will have only AI and no PI ( closed pipe ) and when you are retired the situation reverses. RME will never be a closed pipe and it is not easy to control the outflow also, similar situation for RAE. You can control the flow of the others or even stop them as needed. IS is what you are left with for investing.
I will be interested in knowing whether you have understood the extended money equation and can relate it to your own situation. As this post has already got quite long, I will deal with the practical usage of the extended money equation in a future post.
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