Economics is the study of how to allocate limited resources to best meet certain needs. In an earlier post I talked about financial independence being one major life goal. Today I want to talk about how you can use your personal economy to work toward financial independence. I first came across this framework at a talk by Sarah Newcomb from the Morningstar team.
How can you map the resources you have available to meet your needs?
First, let’s categorize the needs that you have. These fall into three broad categories: your past, your present, and your future.
The past are expenses you are paying for today for something you have purchased earlier. An example of this would be an EMI on a phone you bought a few months back.
Your present needs are your normal everyday expenses, your Amazon prime subscription, phone bill, groceries and so on.
Your future needs are the money that you will require after some time. This could be a house you are planning to buy, the future cost of your children’s education, any medical procedures you may be saving for and so on.
Second, let’s categorize your resources. These can be neatly divided into three buckets: land, labor and capital.
Land is the property you own.
Labor is the income from the work you do.
Capital is any other investment you have; these can be financial investments or even the investments made in continuing education to upgrade knowledge and skills so that you can earn more in the future.
Now we have defined our needs and our resources. How do we match them?
Let’s take an example of Neha, a young professional who is just starting out her career. Today her needs: past, present and future are being met from the “labor” of her salary.
If she has planned well, she would be investing her income to build up her “land” and “capital” for the future. She may be investing in SIPs or in deposits to ultimately buy a house. Or she may be setting money aside to take a professional course that can help boost her career.
At some point, her investments will start to pay her back with income. Her property may start earning rent, her investments may start to pay dividend, her fixed deposits may pay her interest.
And eventually, the income she gets from building up her “land” and “capital” will be sufficient to fund all of her needs. This is the point at which she reaches financial freedom. Now she has the choice not to work anymore and the income from her assets can pay for her expenses.
Directing your “future” funds into land or capital over time can help to build up income sources to eventually replace your income from labor. This is crucial and without it, financial independence is simply not possible.
This framework helps us put investments into perspective. The point of investing is to store up land and capital that will provide you with sustainable income. Focusing on that can help you weigh your choices related to how to allocate your money today toward your past, present and future needs.