Sunday , 25 June 2017

Chapter 1: Investing Basics

Have you ever wished you could give up your job to live life on your own terms, without having any money troubles? Do you find that your expenses increase by geometric progression, while your yearly raise and bonus increases by arithmetic progression? Do you find it unfair that the rich seem to grow richer almost effortlessly, while most of us ordinary folk struggle to save even meagre amounts?

If you answered ‘Yes’ to any of these questions, then it’s time to re-think your savings and investment strategy. Investing is not about parking a little money in the bank every few months. It may not be rocket science; but it’s no cake walk either. A good investment strategy needs both, time and money.

Why invest?
Until a few years ago, it was common for people to stay in the same job all their working lives. But today, unlike in a cushy government job, where one gets pension that has a dearness allowance built in (to take some of the bite off inflation), most people work in the private sector, without any guaranteed job security. Thus, the only way to secure old age is to invest now, when one is young and capable of earning.

For the ‘sandwich’ generation, i.e., the ones who look after their aged parents and take care of their children’s needs today, but can’t depend upon their children to look after them in their old age, it’s all the more critical that they make the most of their earning years and invest for their future needs. If that sounds intimidating, take heart. All you need to get started is a primer on investing. That’s what this book is about.

To begin, investment is all about making your money earn you more money. Simply put, it is the practice of making your money work for you, rather than you working for your money.

Understanding cash flow
When you examine the various entries in your bank statements, you will find that the credits into your account come from one or more of the following sources:

  1. Salary,
  2. Business and
  3. Investment income (interest, dividends, etc.)

Now let’s look at where your hard earned money vanishes each month:

  1. Expenses
    • Essentials (house rent, utility payments, food, and clothing)
    • Non-essentials (the new flat screen television, the designer bag or perfume, the latest mobile or other forms of consumption expenditure)
  2. Taxes, over which most salaried people have little control; and

  3. Investments (money spent in obtaining insurance, stocks, bonds, mutual funds, fixed deposits, etc.), which, unfortunately comes last in the order of priority for most people.

the secret to getting rich is to pay yourself first (i.e., invest for your future), before you pay others (utilities, shops, etc).
Investments must, hence, be foremost in the order of priority barring any financial emergency. That way, you’re sure of saving a particular amount each month; in addition, it may also encourage you to limit your spends within your means.

Where to invest?
There are so many different investment avenues such as stocks, mutual funds, government bonds, post office schemes, bank fixed deposits, commodities, gold, real estate, art etc., that a regular person might be scared of the whole exercise. If your usual investment strategy is to dash off to the local bank and put your money into a fixed deposit (FD), then it’s time to re-think. There’s nothing wrong with FDs. They are time tested, safe, and in the current interest rate scenario, also attractive. However, if your aim is to create wealth to achieve short-term and long term financial goals (foreign vacation, children’s education and marriage, retirement and so on), FDs lag sadly behind other forms of investment. Although banks may appear to offer attractive interest rates on FDs, the fact is that they often fail to keep up with inflation.

Inflation
You have heard about it, but do you really know what it means? Inflation is the rate at which the cost of goods and services rises. Simply put, as inflation goes up, your purchasing power decreases. Much like what is happening in the real estate sector now. As real estate prices and interest rates on loans increase, buyers are forced to consider smaller houses in far flung localities. Three years ago, you could have bought a three bedroom apartment in a premium suburb of Mumbai for Rs 75 lakh; today, the same amount will probably get you a one bedroom apartment in the same locality! Thus, your purchasing power has reduced. That’s exactly what inflation does to your savings over time – it reduces the value of your money.

Impact of inflation on financial goals
This simply means that over the years, you have to spend more in order to maintain your standard of living. What about other expenses like retirement and planning for your children’s higher education? Well, obviously, those will cost dramatically more too. A management course that costs Rs 15 lakh today will cost around Rs 41 lakh (at 7 per cent inflation), 15 years hence when your child is ready for it!

In order to meet that expense after 15 years, you will have to block more than Rs 11 lakh today in an FD @ 9%. If you take into account taxation, this figure will be even higher. Hence, even if FDs may marginally beat inflation, this is clearly not enough in the long run, especially for salaried individuals.

The following table shows the comparative cost of certain life goals now, and the expected cost after 15 and 20 years, assuming an inflation rate of 7 per cent.

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Real return
Can you beat inflation? Definitely, but putting your money in a FD is not the way to go about it. To fight inflation, you must invest in a product which gives you not just a higher rate of interest than inflation, but also leaves you with a substantial amount that enables you to meet your goals. If not, you will find that the value of your investment has actually reduced! Shocked? Let’s see why this happens.

An investment that offers a return of 10 per cent per annum sounds quite good. But are you really going to earn so much? The answer is ‘No’. You have to factor in inflation to find out your actual earnings. This is called the “real return”. To calculate the real return, you need to subtract the rate of inflation from the stated return. So, assuming an inflation rate of 7 per cent, your real return will be 10 – 7 = 3 per cent.

In addition, if you take into account the tax implications, the real return might be even lower. A 30 per cent tax on your 10 per cent interest income would knock off 3 per cent, which is your real return. That doesn’t sound as good, does it? So the next time you have money to invest, keep in mind the real return, and not the advertised one. Thus, you might consider investments such as equities, real estate, and commodities which are relatively insured from inflation, as compared to FDs.

Accelerate your earnings: The concept of reinvestment
It’s rather simple to make your money work for you. Do you spend the interest you earn on FDs or do you invest it in another avenue, i.e., reinvest it? The simple act of reinvesting the interest earned means you earn interest on the interest and make more money. Isn’t that making your money work for you?

Suppose you invested a sum of Rs 2 lakh in the Post Office Monthly Income Scheme (MIS) @ 8 per cent per annum. Every month, a sum of Rs 1,333 will be deposited into your savings account, for a period of 6 years. “Where should i invest such a small amount?”, you may ask. Well, the Department of Posts has a Recurring Deposit (RD) scheme, where you can invest as little as Rs 10 each month @ 8 per cent per annum. Your MIS interest over 5 years would be Rs 80,000. Reinvesting would, hence, earn you an additional interest of 8 per cent on the Rs 80,000, without much effort.

Investment avenues such as equities and mutual funds often have a much higher rate of return than FDs and MIS. Imagine how much more you can reinvest. Another advantage of reinvesting is that it can help you reach your financial goals faster.

The following example demonstrates how reinvestment over a longer time period can boost your income. Anita and Sunita are 25 years old. Anita invests Rs 10,000 @ 7 per cent (compounded annually) today. Ten years later, Sunita decided she would like to do the same. When they turn 60, they decide to see how much money they have earned.

Anita’s Rs 10,000 grows to Rs 1,06,765.81, while Sunita’s Rs 10,000 grows to only Rs 54,274.32! How can the difference be so vast considering that both invested the same amount of money at the same interest rate? The answer is time. Anita begins 10 years earlier and thus earns more interest, which is reinvested, and consequently helps her investment grow exponentially.

Hence, your investment needs time and reinvestment of the interest, dividends, and other profits that you get from your original investment. Further, the longer you reinvest your interest income, the higher your original investment grows, and the faster you reach your financial goals.

That means, if you plan to save for your retirement, the earlier you begin the lesser you will have to invest to build a bigger nest egg.

The following table demonstrates the value of Rs 10,000 invested at 7 per cent over a period of 35 years, assuming that the interest is reinvested.

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The power of compounding
What exactly is the power of compounding and how can a regular person use it to his or her advantage? Well, to begin with, it goes hand in hand with the concept of reinvestment. Every time you reinvest your income from interest on investments, your capital or principal that is invested goes up. The next time you earn interest, it is on this enhanced capital, and is therefore higher than what you would have received if you chose not to reinvest. Over a period of time, these small extra amounts can add up to a tidy sum. In fact, Albert Einstein, once called compounding the greatest mathematical discovery ever.

Apart from time, another factor that influences compounding is the frequency of compounding. You’ve probably heard of investments that offer monthly, quarterly and annual compounding. The shorter the compounding frequency, the more interest you earn, the more interest you reinvest, and the faster your money grows.

Taking our previous example of a person saving for his son’s management education, instead of blocking more than Rs 11 lakh today in a FD, he would need to invest approximately Rs 10,900 per month if an RD is available @ 9% (compounded monthly), which is nearly the same as his monthly savings of Rs 10,000. Thus the frequency of compounding has a crucial role to play in investment planning.

The following table demonstrates the effect of compounding across different frequencies, for a sum of Rs 10,000 @ 9 per cent per annum for 10 years.

image003

Thus, after 10 years, the investment which was compounded monthly grew by almost Rs 1000 more, than the investment which was compounded annually.

Compounding is such a powerful financial tool that if you invest and reinvest your savings and profits regularly, your investment portfolio will steadily outgrow your salary!

Now that you have understood the basic tenets of cash flows, inflation and compounding, let’s understand financial planning and its need.

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