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Build leverage.

Prem Sagar has an interesting post about active investing versus a fill-it-shut-it-forget-it (sorry Hero Honda) approach:

Say, you have 50 lakhs to invest.
Say, you have 50 lakhs to invest.

The average performance of the market might be around 12-15%.

And you are clever that you beat the market hands down by a huge margin. Say 50% or more. Say around 18-25% PA.

Your 50 lakhs after a year in the average folio rises to 56-57.5 lakhs.

But as a active super performer, you could have taken it to 60-62.5 lakhs. (assumption)

So the cost of active involvement was around 4-6.5 lakhs. Do you think thats an attractive ROI? Could you in any way have put this time to better use? Well, only you can tell.

In a further comment he says:

My final thought is this. I have mentioned this previously. You can
1. Earn more
2. save more
3. Invest the savings cleverly.
Step 3 can be delegated. Step 1 cannot be delegated. That is where my focus is currently.

(What I said there and an expansion follows)

Interesting thought there. But firstly the difference between an active investor and a passive one is usually much much higher – for the successful folks it can be even 100%.

Some of the best fund managers (who do this full time) have gotten gains of 150-200% annually (see John Arnold) Even in India, there are a number of investors that average more than 50% on their returns. In fact if you use products such as derivatives you can leverage the money to make larger investments and recoup your money.

When you take the same 50 lakhs and put a differential of say 40% on it, you get a sum of 20 lakhs (on which you pay a tax of only 10% short term gains, versus the 30%+ you pay on salary). 20 lakhs is probably more worth the effort.

Whilst focussing on earning more is important, you are limiting yourself to your earning capacity if you focus on your salaried job.

To put it in investing terminology, you have a leverage factor of 1 => the amount you work = a salary of x gets paid. More work = more pay.

As you grow older, you get leveragable assets – experience and contacts. You can now work less (relying on your experience and contacts) and earn just as much, or work just as much and earn more, increasing your leverage factor to say 4.

If you started a company, you can pay OTHER people to work for you and earn money. This is difficult and fraught with risk, but if you succeed you can increase your leverage to say 20. (For each unit of work you get 20x the return as compared to the salary you would earn)

When your money works for you you will further increase your leverage, sometimes to infinity by living off fixed deposits!

What I’m saying is: Focus on increasing your leverage. Whether it is by active investing or working or starting a company, your aim is to build assets that can be leveraged. (Money or company ownership)

Essentially get to a stage where you can make your assets working for you, instead of your having to work. This may involve innovative ways of thinking, or simply applying common sense.

Example: Doctors have no leverage. They have to work, otherwise they don’t get paid. Right? Well, they have a way out. They will build certain leverages – specialised degrees, experience and fame – and get to a point where they can earn more. For instance, Neurosurgeons get paid more than general practitioners.

To further leverage, they can build a hospital. (See Madhu Trehan, Dr. Devi Shetty and so on). Having a hospital means that when you get old enough that your hands shake and you can no longer operate, you still have something that keeps giving you income.

If you’re not a doctor, don’t be depressed (or you’ll need one). You can still create assets. For one, Active investing can speed up the process if you’re good. Meaning, investing in companies that will beat the indices, tracking your investments and covering your capital from losses.

And you will notice that the more leverage you have, the lesser taxes you pay 🙂 (as a percentage of income)

  • Salary income has the highest tax: 33% highest bracket with very few deductions
  • Business income (consultancy etc.) still has 33%, but you can deduct stuff like depreciation on your car, phone expenses, travel expenses etc.
  • Company ownership – apart from expenses, dividends are tax free (company pays 15% DDT)
  • Stock market investments – long term gains are tax free, 10% on short term gains.

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