Thursday, 25 February 2016

P&L - Income

In my previous post, I did mention that the first thing you should do is to get your personal finance situation in order first before focusing on investments. This is an important process since it actually determines your risk appetite and the nature of your investments. I was debating between writing about income & expenses or assets & liabilities but decided to go with the P&L aspect since it's probably more relevant on a personal level.

Profit & Loss (P&L)

I find that the accounting approach to your own personal finance situation is a good way to manage this aspect of your life. Think of it as a monthly P&L statement that eventually forms your annual P&L statement. There are 2 main components of a P&L statement - Income and Expenses.

Income

There are broadly 2 types of income you can receive.

Active income refers to income for which services have been performed. For employees like us, this is likely to be your salary, bonus, allowance etc. If you have a side venture or are self-employed, the business income will form part of your active income as well.

Passive income refers to income from enterprises in which you are not actively involved. For the majority of people, this is likely to be interest from government or corporate bond holdings and dividend from stock, fund or unit trust holdings.

Active Income

For most of us, the type of industry and job will determine a significant portion of your active income. How you navigate your career (skills development, job switch, salary negotiation etc) will largely impact the monthly active income you receive now and in the future.

You must understand the nature of your active income well, especially how stable it is. Given that you are more likely to start off with active income comprising most of your total income at the start, the key is to ensure that the source of this active income is stable and increasing over time. Whether your salary is high or not does have an impact on how long this journey to Financial Independence will be. However, the more essential point to note is that the more regular and consistent your salary is, the more it allows you to plan and work on improving your personal finance and investment situation.

Ideally, you can develop another source of active income such as from a side-venture. This can be useful in the event of job loss and any other contingencies. In fact, it's something that we are still trying to work out ourselves. We understand its importance but the effort and time needed to build it up on top of having to work can be a real buzzkill. Just have to keep trying!

Passive Income

Most people already receive some form of passive income - interest from your bank accounts. The difficult bit is to develop other sources of passive income. However, it's still important to maximise the interest earned from your bank accounts. Cash holdings for savings and investments may be idle but you should try to increase the rate of return on them, especially in a low interest rate environment like Singapore. It's surprising how many people here have no idea what is the interest rate on their bank accounts and end up earning 0.05% - 0.25% pa. It's actually possible to earn at least 1% pa on most of your cash holdings and I will write about this in future posts. My opinion is that you should learn about this bit first before going on to invest in bonds, shares, ETFs etc. At a minimum, you would have picked up valuable research & analysis skills that will be useful to your investing journey.

The other common source of passive income is rent from real property. This can be from renting out a room or the entire property. It's a highly popular source of passive income because most people can understand how to generate it. I suspect it's because we all played Monopoly when we were young and it's actually one of the earliest & significant financial education influence we were exposed to.

The last source of passive income from bonds, shares, ETFs etc is probably the hardest to pick up. It requires some level of natural interest in finding out more about these financial assets and learning about the businesses you are investing in. The time taken to monitor these investments depend largely on your strategy. However, the upfront investment of time to learn and build your portfolio will almost always be significant. Nevertheless, the payoff will be worth it as long as you have the belief to see it through.

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