In this post i would be discussing on investment basics right from finding money to invest,where ,how and when to invest.
1.
Finding money for Investment!
Savings = Income (or salary)- Expenses
For most of you this formula doesn’t work ( as you would have already experienced ) since when money is in your pocket, you get trapped by advertising tricks like discount offers on Clothes or new gadgets which tempts you to spend more. It’s difficult to control expenses. As a result, your savings never hits the target. If what we said holds true for you and you seriously want to save a fixed 10% or 20% of your take home salary each month, you need a different approach to savings. Instead of trying to limit your expenses every month, first deduct an amount which you intend to save and keep it in a separate account so that you live with only what’s left. So our formula has to be modified like this :
INCOME – SAVINGS (INVESTING FUND) = EXPENSES
Smart! Isn’t it? This formula forces you to “pay yourself first,” before the other expenses. That way you know your savings will not get lost in the daily grind of living expenses.The other side of this formula is a forced discipline. You hold your expenses to no more than 90% of your take home pay.You can even automate the process by having 10% (or any amount you want) deducted from your Salary account and transfer it into a separate account or fixed deposit, recurring deposit or other savings instrument .So that’s the basic trick to find money!
MORE TIPS TO CONTROL YOUR EXPENSES:
SPEND LESS
This is one simple method to save more. Sit back and analyze your spending habits and look where you spend more unnecessarily. Once you have identified certain areas of high spending, try to find ways to cut back. Take a decision that you’ll not spend more than a fixed budget.
MAKE A BUDGET
A budget is a very important tool to control expenses. Be it individuals or corporates. A budget is nothing but a chart or a statement that shows how much you earn and hence, how much you can spend.You can make a budget planner on a microsoft excel sheet or you could also try google wallet.
PAY OFF YOUR LOANS
Loans carry high rates of interest. If you have a lot of EMI’s to pay, it naturally reduces your capacity to save more. It also shows that you’re living on high levels of debt which is not a right thing to do. If you have loans, first look for ways to pre-pay it as soon as possible.
THINK BEFORE YOU BUY
Do not buy anything on impulse. Before laying your hands on any fancy thing which is up for sale, think if it’s really needed. Better avoid taking your lady love for shopping often :)
SHOP SMART
Most of the big brands will be available at throw away prices once there’s an off season sale or sales promotion drive. For example if you want to buy an expensive watch, wait for the company to announce some discount offers. All the big brands announce discount offers at least twice a year.
KEEP DISTANCE FROM LAVISH FRIENDS
High spending lavish friends are may hinder your route to save money. It’s natural for you to get tempted by such friends to buy new gadgets every year. They may be nice guys and may not harm you in anyway, but to keep up with them, it may become necessary for you to spend high (for example latest electronic items or cars, parties, expensive dress etc. ) which otherwise may not be required.
2.
Time is money!
The best money advice anyone can ever give you is the “time value of money” concept. Every financial decision involves the application of this concept directly or indirectly. The calculation of time value involves simple mathematics and it’s easy to calculate. The principle is – Rs 100 today is more valuable than Rs 100 a year from now. The reasons for this is quite simple to understand -
• First, since the cost of living goes up , your money will buy less goods and services in the future .So, today, money has more value or the purchasing power of your money is more
• Second, if you have that money today, you can invest and earn returns. When you receive the money at a future date instead of receiving it today, you lose the interest or profit you would have made, had this money been with you now.
• Third, you prefer to have money today since the future is uncertain.
EXAMPLE:
Let’s assume that you are 25 years old. You earn 35000 per month. Your monthly expenses are 20000 and 5000 for insurance. The rest 10000 would be your savings. Let’s assume you make this investment for 35 years. What amount would you be receiving at maturity. There is a formula you could apply or could use any of the online calculators available. So as you could see in the screenshot below you would have 2,40,11,813 assuming the rate of inflation as 5.5%. And remember the earlier you invest the more you get.
FV = pmt (1+i)n
FV = Future Value
Pmt = Payment
I = Rate of return you expect to earn
N = Number of years
Now that savings is huge. Imagine what a retirement life you could enjoy.So make plans to retire early as possible, live life happily.
3.
Compound Interest
When asked to name the greatest mathematical discovery, Albert Einstein, one of the most influential and best known scientist and intellectual of all time replied
“compound interest”
Let’s try to understand why he said so with a very simple example:
• Jerry starts saving when he turned 25 and invests Rs 50,000 every year. He earns a return of 10% every year. At the end of ten years; he has been able to accumulate Rs 8.77 lakh. After that, he doesn’t invest Rs 50,000 anymore. He leaves that investment there until he’s retires at 60. At that time, he would have accumulated around Rs 95 lakhs.
• Tom, had fun and lived his first few years spending on all kinds of things and did not think of investing regularly. At 35, he starts to invest Rs 50,000 regularly every year until he retires at 60. I.e. for 25 years. But, he would have managed to accumulate only Rs 54.1 lakhs which is around Rs 41 lakhs less in comparison to Jerry.
Compounding is very powerful.As Napoleon hill has said- “make your money work hard for you, and you will not have to work so hard for it” To take advantage of it, you have to start investing as early as possible.The earlier you start, the better it gets.
Here is an example which would make things simple.
Let’s assume that you invest Rs 10,000 annually. Your retirement age is 60. Let’s also assume that the interest rate you get is 10%.
At the age of 60 you will have -
• 49 lakhs -if you had started investing from age 20.
• 30 lakhs -if you had started investing from age 25.
• 18 lakhs – if you had started investing from age 30.
• 11 lakhs – if you had started investing from age 35.
• Just 6 lakhs – If you start at 40!! Take note of the impact.
Generally what I find is that most of the Indians start thinking of saving and investing at the age of 30-35. The above calculation is made assuming that the interest rate you get is 10 percent. But the average interest rate of banks is less than that. I hope the picture is now clear for you. The more you delay, the more you need to invest.
4.
Bank Interest rates.
Interest,
usually expressed in terms of a percentage, is the additional amount you pay
for using borrowed money or the return you get when you invest it with a bank. If you think clearly, the two concepts we
discussed earlier, time value of money and compounding were based on the
concept of interest rates. In this post we are discussing certain practical
scenarios where interest rates can baffle you. It’s discussed under two heads
1.
Interest payments
2.
Interest incomes.
INTEREST
ON LOANS
Interest
rates are always tricky. In most of the
cases, interest rates advertised by the banks are not the actual rate of
interest you pay. It’s something more than that.
Trap 1
When
you apply for a loan, there are a lot of financial charges you need to consider
before deciding whether to avail it or not. For example – you are offered a
loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s
payable in advance. Effectively, you are getting only Rs 164,000 in hand. But
since the interest rate is calculated as if the entire 2 lakhs is given to you,
the rate of interest you pay is actually very high.
Is
that all? No. The bank will also deduct a processing fee of 1 % of the ‘total
amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.
Trap 2
You
are offered the same loan for reducing balance interest. You feel light
thinking of the fact that interest is charged only on the balance outstanding.
But look closer – reducing balance can be on monthly basis, half yearly basis
or on Annual basis. If it’s on annual basis – your interest is calculated on
the amount outstanding at the ‘beginning’ of the year. So, you keep paying
interest on a higher amount even though your loan is decreasing every month.
This pushes up the effective rate of interest you pay.So always confirm whether
the reducing balance is on annual basis or half yearly basis.
Trap 3
Higher
loan pre-closure charges. The bank would like you to pay your EMI’s regularly.
If you do that, the bank likes you so much that on the basis of that regular
loan track, they will sanction a second loan if you want. But – if you try to
close off your loan liability before the stipulated loan period – the bank will
charge an additional amount of 3% to 4% on the outstanding principal. They don’t
want their customers to be ‘Too regular’.strange isn’t it?. That’s the way bank
deals with it’s customers. If you try to be too good , you’ll be fined This
preclosure charge you pay effectively raises the cost of your loan.
The
solution-
The
best way to deal with these traps is to stop comparing the interest rates and
instead, compare the EMI’s and compute the total amount going out of your
pocket including processing fee and pre-closure charges. This will give you the
right picture of which loan is actually right for you.
INTEREST
ON SAVINGS
The
principle to be applied is quite simple – The earlier you get it, the better it
is.
This
principle will help you to compare different offers. For example – A bank
offers 8% P.a interest on FD , payable
annually. NSC-National Savings Certificate also offers 8% P.a but, payable half
yearly. You get another offer on FD which pays interest at 8% p.a – payable
monthly. Which is better? The one you get on monthly basis, of course!. Why?
Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16%
and the third option of FD gives you an effective annual interest rate of 8.30%
!
How?
Let’s calculate with an example –
• Let’s assume that you have 2 lakhs
with you.
• The first bank would give you 8% –
annually so, you receive an interest income of Rs.16,000 at the end of one
year.
• Suppose you depoited the same with
NSCThey would give you 8% -half yearly.
So, at the end of 6 months you get Rs 8,000 which can be again invested for 8%
interest for 6 months whch gives you an additional interest of Rs. 340. So, the
total interest you receive is now Rs 16,340. effective rate – 8.16%
• Similarly , when you work out 8%
interest received on a monthly basis the effective interest rate would workout
to 8.30%.
5. Cash reserves and idle cash.
Cash
reserves are money kept aside as an emergency fund. We are discussing the need
to keep cash reserves as our fifth principle because, this is one important
idea which most of us neglect. When you set aside some money from your earnings
to meet unexpected expenses, there are four advantages that automatically comes
with it:
1.
Financial safety.
2.
It allows you to take advantage of a surprise financial opportunity
3.
It creates a compulsory saving habit.
4.
Since funds are kept in liquid cash or gold, it earns interest or appreciates
in value.
I
recommend to create an emergency fund that equals to 4 or 5 months of living
expenses; however, you do not need to set aside this total amount in cash
alone. It can be in short term fixed deposit or Gold etc..
HOW
MUCH RESERVE?
That
depends from person to person.
1.
AGE:
2.
OCCUPATION:
3.
HEALTH CONDITION:
4.
MONTHLY EMIs.
5.
NUMBER OF MEMBERS IN FAMILY.
6.
OTHER SOURCES OF INCOME
7.
OTHER POSSIBLE EXPENSES.
HOW
TO KEEP RESERVE FUNDS?
Hundred
percent of your reserve funds need not be kept in liquid cash. A portion of it
can be kept in short term fixed deposits or debt funds and a certain portion in
gold or easily marketable securities.
Any
cash lying idle over and above your emergency fund results in a lost investment
opportunity. You are not making your money work efficiently for you.
6: Don’t break
the Limit!
Money
will come and go; after all, you just have a life to live –why not live it to
the fullest? Sounds perfect and positive, isn’t it? Unfortunately, if you are
living your life like that, not everything is positive and perfect. You will
realize the perils of reckless spending when you face a financial emergency.
The principle is not very hard to follow – never take money from your savings
or borrow temporarily from your friend’s pocket to buy a little more luxury. Be
it a slightly bigger house that caught your wife’s imagination or the latest
electronic gadgets.
WHERE
IS THE PROBLEM?
The
lifestyle you want to maintain depends on three factors:
• The circumstances in which you were
born and bought up
• The kind of friends you have
• The place or community where you
live.
Have
you asked your parents about how they started their life? They din’t have a big
car or latest electronic gadgets. They probably didn’t live in the big
apartment or villa they’re living right now. They built everything brick by
brick. It would have taken a lot of time, effort and disciplined life to get to
where they are now. That’s exactly the way you should also start off. If you
try to achieve all the life’s goodies in very short time, there’s every
possibility that you’ll borrow a lot of money assuming that you’ve the ability
to re-pay everything in 5 or 10 years and chances are that you’ll get into debt
trap should there be an unexpected fall in your monthly income.
7. Don’t try
‘Get rich quick’ Ponzi schemes
How
about getting some money quickly? I have an offer- All you have to do is to
join this site for a small fee of 1000 and then keep introducing others to it.
For every person that joins by giving 1000 through your reference, I will pay
250 to you. Give me 1000 subscriptions
and take home 25000!! Sounds good? The truth is that such schemes don’t work. If any of you were attracted to my scheme,
definitely you’re lazy and have greed for money.
8. Inflation
In simple terms inflation is nothing but rise in the general level of prices of goods and services Or in other words the value of your currency has gone down, and hence, you need more of it to buy the same quantity of goods.
HOW
DOES IT AFFECT YOU ?
Let’s try to understand with an example-
Sisters Marriage party
Your sisters marriage is one year from now, you are supposed to make some arrangements
for a party. To make a budget, you enquire at the event manager about the costs and they say it would cost one lakh right now but they cannot guarantee the same price 1 year down the lane, because the cost of materials can go up. So you immediately put this money in a deposit that would give you 8% return by the year end. At the end of year 1, you have 108,000 with you. (Let’s ignore tax).
Now, its one year and you have to celebrate your sister’s marriage. Let’s assume that the inflation during the year was at 10%. That means the general price levels of all products have risen by 10% and hence your event manager is going to bill you 110,000 for a party instead of 100,000 earlier. So to arrange a party now, you have to incur an additional expense of 2,000 from your pocket. Why? Because, the money you have, has lost its value to the extent of 2,000. And, you could manage to make a return of only 8,000. If the general price levels moves up at this rate, it would cost you more than 250,000 to host your marriage 10years later! Had you managed your money to get a return of 10%, you wouldn’t have to spend that additional 2000 from your pocket.
That’s inflation for you – try to understand this vital principle in order to manage your money. So, if you are getting 8% on a 10 lakh Fixed Deposit and if the inflation rate is 8%, do you think you have gained a penny? - No. Inflation eats away the value of your money. The only way then, is to target a return on investments that would beat the rate of inflation.
REAL RETURNS
Many people while measuring the returns on their investment, forget to consider the effect of inflation. But that’s not the correct way to measure returns. Returns calculated without considering the effect of inflation is called nominal return. The return calculated after considering the effect of inflation is known as real return. In addition, if you account for tax implications the real return would be even lower. So next time you have money to invest, keep in mind this ‘Real return’ concept. Real return is what you actually earn from investments -and not the advertised rate of return.
HOW DOES INFLATION AFFECT INVESTMENTS?
FIXED INCOME INVESTMENTS
Since fixed income investments are locked into a particular interest rate, your earnings may not keep up should the inflation rate accelerate. The principal you have invested also deteriorates in value if inflation rises steadily over a period of time.
For example –
Let’s assume that your tax rate is 20%. If you invest 2,50,000 that gives you 10% return, you will get 25,000 as return from which you will have to pay 20% tax .
• Amount Invested = 2,50,000
• Maturity Amount = 2,75,000
• Interest Earned = 25,000
• Tax on Interest @ 20% = 5,000
• Net Amount in Hand = 2,70,000
• Interest Earned = (20,000/2,50,000) * 100 = 8%
• If the inflation prevailing is 7%, then Real rate of return/Inflation adjusted return = 8% – 7%= 1%
This implies value of money at your hand has increased only by 1% and not by 10% or 8% although you were under the impression that you were earning 10% on your investments.
STOCK MARKET INVESTMENTS.
Inflation and stock markets are negatively co-related. When inflation is high, it hinders economic growth of the country and such a scenario would definitely affect stock prices negatively.So as inflation increases, stocks tend to perform poorly.
GOLD AND SILVER INVESTMENTS.
The reverse would happen to gold and silver. Since stocks are not attractive, investors would naturally resort to gold and silver which are safe havens. Gold and silver go up during inflation. The reason is that, as inflation begins to creep up, the purchasing power of paper currency loses it value. Once paper currency has been invested into this precious metal, it will not lose its value as a result of inflation.
9. Insurance is
a must.
INSURANCE.
One interesting fact about insurance in India is that it’s never bought for the right reasons. In fact it’s wrong to say that it’s bought; it’s actually ‘sold’ by advisors with much strain and effort. Some consider it as an investment; others buy insurance to reduce their tax burden (because of certain tax benefits that’s offered by the Indian income tax Act) some people buy a piece of insurance just to get rid of that advisor who keeps appearing politely every morning at their door step ‘n some buy it because it’s difficult to say ‘no’ to that known guy who could be you relative/banker/friend/ acquaintance. Indians are a bit reluctant to buy insurance. We haven’t searched for the reasons. The reality is that insurance is a must for everyone – simply because it provides security and safety. It doesn’t come free; you have to pay for being safe. The amount you pay is called premium. Insurance can only compensate for the financial loss that occurs due to death of an earning member or serious health issues that requires huge money out flow or loss /theft/damage of expensive assets. Some insurance companies sell policies like ‘child policy’, ‘marriage endowment policy’ etc. These are nothing but life insurance polices in different name and form.
Insurance falls into three categories and we are listing it out in the same order of importance- life, health and then, your assets.
• Medical or health insurance
Life insurance keeps a family safe from the sudden fall in finances just in case something inevitable happens to the earning member of that family.
The second one is to protect your wealth. The cost of hospitalization and medical treatments are going high every day with advancement in medical sciences. A health policy gives the financial support required for availing medical treatments. The last one, is to protect all your assets and belongings against damage, repairs etc. Insurance companies have also come up with innovative products like stock market linked policies. Such policies combine the risk and benefits of stock investments along with insurance protection. But these instruments should be opted after very careful analysis. It is always better to stick to traditional or simple insurance schemes which you can understand.
SELECTING THE POLICY MIX THAT’S RIGHT FOR YOU
Selecting a policy is not a simple task. A financial planner would be the right person to advice you on this. You can also try online calculators to judge the best plan in market.
If you have already opted for insurance, that’s a very positive step you’ve taken Apart from opting for insurance, there are three more important steps to do from the practical point of view. First, All the policy documents must be kept in a file, with a summary written on top of it. Secondly, it should also contain the agent’s number, local office contact number and the 24 hr helpline number of the insurance company. The summary can also contain a description of the steps to be taken in case of an emergency. Finally, you have to teach your nominees about how to make a claim from an insurance company. These steps are very important because, when something happens to you, your family would already be in very tensed and vulnerable situation and that may not be the right time for your loved ones to go clueless on where the documents are kept and how to go about with the claims. It’s no easy process to make a claim. There are several documents to be produced, especially in the case of death claims. It’s more complicated if it’s an early death claim (claim within 3 months). So knowing all this would avoid a lot of stress at that time.
10. Diversify
your investments.
DIVERSIFICATION.
Diversification is one of the central concepts in investments. The theory says that your money should not be locked in any one asset. It should be split to buy different types of assets like land, shares/mutual funds, gold, FD’s etc. The reason is quite simple – no asset class can keep delivering profits year after year consistently. That’s because, every asset moves in a cyclical trend. There will be exceptional growth in some years and then it will be followed by sluggishness. This phenomenon is true in almost every assets class. So, if your investment is in a single asset, you make money only if that asset increases in value and at the same time, you also miss the chance to participate in any other asset boom. Hence, the risk you take is high. For example – what would happen if you’ve put all your money into stocks and the stock market tumbles? The way to reduce such risks is to diversify your money into various assets. In fact, diversification is one of the cardinal rules of investments.
DO NOT GET INTO TROUBLE.
You have to diversify and make sure that your funds are in different baskets. Fine. But that does not mean that you should put your money into as many baskets as possible!! That results in over diversification. An over diversified portfolio would be very hard to monitor. Periodic monitoring of your investments and re-balancing of investments between various asset classes is necessary to keep your portfolio growing
HOW TO ALLOCATE YOUR MONEY?
The basic idea of diversification is to have different kinds of investments. That means you should have some or all of the following assets in your kitty-
• Stocks.
• Bonds and Fixed deposits.
• Real estate.
• Cash.
• Gold.
That
was a general example. The ratio of diversification depends on a person’s risk bearing
capacity, age, financial goals, amount of funds invested and many other
personal factors. It’s important for everyone to sit with an investment
consultant and draw up a plan like this.
11. Valuation is the key to right investments.
VALUATION
Every
asset has a ‘true’ value which would be different from its market price. That’s
common knowledge. The market price of any asset purely depends on the changes
in demand and supply equation and hence, it could be more or less than the true
value of the asset. So, when should you enter the market and buy the asset (let
it be any asset)? That’s what we will explain in our 23rd principle.
The
simple rule is that an asset should be bought when it is available at a bargain
so that in future, when the asset gains in value, the profits you make is high.
The question is what’s the basic process to know an asset’s true value? The
answer lies in a process called valuation.
To
put it straight – valuation is an attempt to know what an asset is ‘really’
worth. All assets like gold, land, villas and apartments, arts, antique pieces,
shares, bonds, mutual funds or even cars and electronic items have to be valued
so that you have a reasonable estimate of what you’re going to get for the
money you pay.
IS
IT POSSIBLE TO VALUE ANY ASSET?
Yes.
It’s possible. It’s practical too. However, the level of knowledge required to
value an asset depends on the asset type and also your knowledge about the
particular asset.All assets types are not easy to value. Some may require an expert’s help or opinion. Different methods are used to value different
assets – for example the method used to value a property is entirely different
from the method used to value mutual funds. Whatever be the valuated figure,
remember that it is still based on certain estimates and assumptions. Hence,
valuation itself is not fool proof. There will be an element of uncertainty
in value estimates.
Valuation
is not a new concept. We do a lot of valuation in our daily lives. Let’s take the example of a couple who wants
to buy a new villa. How would they know if the offer price of the villa is not
overstated? The solution is to approach a registered property valuator who will
visit the site put the right price tag for it. Then, find out how much others
have paid for similar properties in that area. Buy it only if the price quoted
approximately matches with the valuator’s opinion. Lower the price, better the
bargain.
WHY
VALUATION IS THE CORE?
• Any asset is prone to overvaluation
as the demand for it increases.
• These overvaluations can continue for
many years and one day, it will eventually burst and cause the price to fall
lower than its fair value. We have already witnessed this scenario in 2007-08.
• High demand is only one of the
reasons for over valuation. Asset prices will be inflated if there is excess
money in the financial system, high speculative activity, reckless lending by
banks, low interest rates etc…
• Herd behavior or the tendency to
follow what the crowd is doing is also another reason why over valued assets
are traded in the market.
• In a bull market (for any asset in
general) investors ignore valuation and concentrate on the trend of price
movement. They chase prices and focus on the possibility of resale of the
asset. When they see the trend of rising prices, they buy those assets in hope
of profiting from the increase in value.
• It’s just like gambling at casinos.
The game goes on and on and someone, at the end, will lose all his money
So,
high price paid for an asset cannot be justified by merely using the argument
that –
• There are other investors waiting to
buy this asset and hence, even if we pay a higher price, it can be sold to the
next highest bidder.
• Technically, the demand is high and
the supply is short and hence, the prices will keep moving up.
• This is the new hot asset on the
block, everyone is buying it.
Hence,
arguments in support of high asset prices are absurd. Be it shares or mutual
funds or property or currency- irrespective of the asset you choose to invest,
buying decisions should be based on valuation or else, you will end up buying
the assets at an inflated price.
A
general indication that an asset market has started getting overvalued is when-
• The general public are investing
their money on the asset
• There are many first-time investors
entering the market.
• Everywhere you observe people talking
about the same asset.
• There’s a lot of hype and stories
circulating around like – the story of a taxi driver who made a killing from
the market or the story of an employee who resigned to take up investing as a
full time profession and made millions.
• There’s a lot of warning bells
ringing around, but no one cares to listen and the asset price keeps going
north.
LA FIN:
Even valuation is not
fool proof ! At the end of the most
careful and detailed valuation, there will still be uncertainty about the final numbers since these are based on certain assumptions.
