Starter Basics for Starting Your Investments

Here’s a masterclass on how to blow away Rs 60 crore. “Part of the money went for gambling, part for horses, and part for women. The rest I spent foolishly.”

Well, this is the explanation given by late actor George Raft and perhaps we can learn from him.

But seriously, we want to talk about investing money instead of just spending it. It’s about learning the simple concepts of Pay Yourself First, Power of compounding, Rupee Cost Averaging, Risk Analysis, Asset Allocation and Financial Planning.

And once you have taken those investing lessons, it’s time to get started. Often young people spend their time finding the “best” investments instead of just getting started. Some people get bogged down by the information overload or get confused with the multiple choice and options and get into a “decision paralysis”.

This article is about the little things that you must know to get started. You’ll find the concepts very easy and simple. Let’s begin.

What are Investments?

An investment is anything you purchase for future income or benefit. In other words, anything not consumed today and saved for future use can be considered an investment.  Income earned from your investments and any appreciation in the value of your investments increases your wealth.

The prime motive behind investing is that we want to maintain and improve our future financial situation.

Three rules of investment:

Invest early

Invest regularly

Invest for long term and not short term

  • Invest Early: The sooner you start the better. Start investing in small amounts, continuously for a long time, money grows due to the power of compounding. If you start investing when you are single you will be able to save maximum.  The best policy is to start saving from the moment you begin earning.
  • Invest Regularly: Develop the habit of adding to your recurring deposit / systematic investment plan of mutual fund / deferred annuity account on a regular basis, perhaps monthly or quarterly. By investing regularly with SIP of mutual funds you take advantage of a strategy called rupee-cost averaging. Regular investing, however, does not ensure a profit or protect against loss in declining market scenario.
  • Invest for Long Term and Not Short Term: If you decide that your money can work for you over a long period of time, then better compounding works. Consider this: Rs 1,000 invested at 8% earns Rs. 80. Left to compound, the original Rs.1,000, plus accumulated interest, will earn Rs.160 in the 10th year, Rs.507 in the 25th year, and Rs.1,609 in the 40th year — returns of 16%, 51%, and 161%, respectively, on the initial  1,000.

Preferences and Risk Tolerance

As Investor, you should want to maximize your returns and minimize risk. There is always a trade-off between risk and return. Risk appetite of investors differs from investor to investor.

Investors who are unwilling to assume risk are satisfied with instruments that give risk-free rate of return.  These investors invest in government bonds, fixed deposits, debt funds offered by mutual funds, etc.  On the other hand when they expect high rate of return, they assume a larger risk. They are risk takers i.e. they are willing to take more risk for getting their expected rate of return. More importantly they manage risk and not just blindly take risks. They invest generally in stocks and equity. There is a wide range of financial assets available to investors, like stocks, futures/options, real estate, and commodities, etc.

Inflation

A simple & commonly used definition of inflation is simply “an increase in the price you pay or a decline in the purchasing power of money”. Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs to buy the goods and services you need to live. Inflation causes money to lose value because it will not buy the same amount of a good or a service in the future as it does now or did in the past. Inflation affects savings of an individual hence one needs to invest wisely to meet the cost of Inflation.

 In other words, For example, if there was a 6% inflation rate for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a factor in any long-term investment strategy. Remember to look at an investment’s ‘actual’ rate of return, which is the return after inflation.

Interest 

A simple definition of interest is an amount charged to the borrower for the privilege of using the lender’s money. When we take a loan of some amount, we are expected to pay for using it – this is known as Interest. Interest is Interest is usually calculated as a percentage of the amount of money borrowed. The percentage rate may be fixed for the life of the loan, or it may be variable, depending on the terms of the loan.

When interest rate in the economy falls, the value of investment in instruments of fixed interest rate and fixed maturity date like fixed deposits, company deposits, annuities rise and investments of long term gives good rate of return.  One year maturity investment will give lower return than fifteen year maturity investment in the falling interest rate scenario.

For example, suppose an investor has invested in fixed deposit @ 10.5% for a period of 5 years, he will get return @10.5% for next five years though the interest rate falls to 8% during the year.  Or suppose immediate annuity contract pays to the annuitant @11% it will pay the same rate of return though the interest rate declines to 8%.

Now after having understood the starter basics, you are ready to begin, right? In the next post, we’ll share how to set up your personal financial system. Stay tuned.

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