Besides general living expenses, everything else money tends to buy is an asset of some sort.
Assets are good, we like to have assets and it’s definitely a good idea too, to have assets. Just that there are two types of assets viz., Consumption Assets & Conservation Assets. I define consumption assets as assets that we consume each day of life in some form or manner. The value of such assets depreciates over time. Accordingly conservation assets are assets that prima facie conserve wealth and over time appreciate in value as well. Often while we are busy and rushing from one meeting to another; from one project to another; from one assignment to another, we manage to create just about one, single conservation asset i.e. our residential home. And that’s more driven by the necessity of having a roof over one’s head and not really from the perspective of wealth creation.
Consumption assets, just far too many
The way we live our lives we quickly tend to create far more consumption assets. Sure it is important to have a blackberry or latest iphone in work circles. It is nice to have the child leaning Japanese handicraft. It is nice to be able to have all window air-conditioners replaced by split ones that a quieter and more stylish. It is nice to be able to upgrade from your old Maruti to a brand new Toyota Altis. It is essential that diwali is spent at exotic & unexplored locations for eg. Turkey. It is perhaps important to have such items as they bring us happiness and place us on a higher stratum of social status. These assets give us a lot of satisfaction and because we feel we can afford it we undertake such purchase decisions. Nothing wrong with this except that for every rupee spent in such assets if we do not forget to spend about double into a conservation asset. It is as simple as that. Over time you will have a vast collection of digital photo, treasure house of goods and pleasant memories and so much to speak about everything in life except your portfolio statement.
Zero or near zero value.
These consumption assets have a general rule. They never appreciate and always fall or depreciate in value. Infact some have zero value as soon as you are done spending e.g. a holiday or a fine-dining experience. This experience is then your asset and in monetary terms once you are done with it the value is zero. Some assets gradually depreciate over time, some not only depreciate but worse, they give us a liability to live with for many years to come e.g. a car with a car loan. As soon as you drive the car out from the showroom it loses anywhere between 10 to 20% of its value. These assets are necessary and no doubt about that. But there might be a better method of doing this.
Extraction of funds
The best way without any element of doubt to buy consumption assets is out of profits of investments. But that is somehow not possible for most people as most people only save and do not really invest, so question of profits for most people is not relevant. Following are 2 scenarios of buying a consumption asset, say a car worth about Rs. 10 lacs.
Option 1:
- You have the money and buy it outright & money is consumed.
- At the end of 5 years your networth on this asset is say 20% of the value i.e. about Rs. 2 lacs.
Option 2:
- You have the money and decide to take a loan for 80% of the value (assuming you can afford the EMI and are eligible for such vehicle loan) and invest your own money smartly.
- You put in 2 lacs as your down payment and EMI being about Rs. 18,000 based on 12% interest rate on your loan.
- Over the end of 5 years you have paid about Rs. 10.7 lacs to purchase the car inclusive of 2.7 lacs being interest.
- At the end of 5 years your networth on this asset is Rs. 7.3 lacs. Wondering how? Your invested 8 lacs are now worth about 16 lacs plus 2 lacs the salvage value of car minus 10.7 lacs paid so far. What are you left with? 7.3 lacs.
- Is this a better option? Surely and this is possible.
Now if you were to follow my rule stated above that for each rupee spend conserve two. This would mean you need to have 20 lacs of investments to be able to buy a 10 lac car. In this case your networth at end of 5 years under suggested option 2 would be about 27 lacs. In this case you would have started your purchase planning 18 lacs and at the end of 5 years you had 27 lacs, excess being 9 lacs. Another way of looking at this is that; the investments you had pretty much paid for the consumption asset. Sure you might feel you can do this only when you have assets aka investments. But you have got to start somewhere first. If you keep spending on consumption without conservation then this will not be possible.
I have a simple guiding rule that I work with; “Consumption i.e. Depreciating assets must pay for themselves because over time they will have little or no value.” Such methods of buying depreciating assets are also a part of prudent Financial Planning. Financial Planning shows you a roadmap of how not to compromise and how to optimise money even while you are purchasing a consumption asset.