Basic concepts and different investment avenues

In this article, I will cover some basic concepts including inflation, compounding, savings, investments, financial planning, various investment avenues etc.

Why save money?

Most of us are earning good amount of money and many think why not spend it all and have fun? Why bother saving any of it as we are confident that we can keep earning in the foreseeable future? Short answer is to be financially secure. For life.

There are needs that require far more amount of money than our monthly salary. You need to pay 2-3 lakhs now a days to get your kid admitted into a good school and there are so many such requirements. True there are banks eager to offer loan for everything but they would expect you to pay back large interest and EMI would drastically reduce amount available to fulfill rest of your needs. 

What do you do if an accident puts you on bed for few months or a recession makes you loose your job and you fail to find another one for a few months? Would you have more peace of mind when you have enough savings to sustain for a few months or when you have nothing?

Everybody is going to become too tired of job some day and would retire. How would he survive if he has no savings? We Indians count on kids too help us out post retirement. I would be lucky if my kid earns enough and is willing to help me out. So am I going to count on my luck? No. I would rather plan, save and invest.

So it's very important that we must save a large amount on money during your productive years so that it would support us during bad time or post retirement. I would encourage you to read following articles:

I Invest, So That I Live Like a Man…Not a Donkey, Dog or Monkey, The Value of Saving and Investing Money

Inflation

We keep hearing about high inflation, CPI, WPI and all that jazz every now and then, but should we really care? Yes because inflation is far more than just a concept as it depicts that purchasing power of money decreasing over time.

As I remember during my childhood, monthly groceries used to cost hardly Rs 1000/- for the family of 4. However now just for the family of 2, even Rs 2000/- not enough just for weekly grocery. The 1 BHK that I rented in 2006 when I came to Bangalore for Rs 5000/- now costs Rs 10000/-. That is 100% growth in just 7 years which is roughly 10% inflation annually.  Prices of groceries, fuel, medicines etc have increased too.

That humble Rs 100/- note used to be far more valuable for my father when he was young. You would call me foolish if I tell you to put  Rs 10000/- in a piggy bank  for retirement because after 30 years, it would hardly be equivalent to about Rs 800/- assuming 8% inflation.

Hence for financial security, just savings are not enough. You need to ensure that you invest it wisely and get more returns than inflation. Inflation has been in double digits in last a few years and it would be safe to assume long term inflation of about 8-9%. Hence if your FD interest is 9%, or ~6.3% after accounting for income tax assuming highest tax bracket, the reality is that value of your savings is decreasing with time. 

Compounding

Hopefully we now agree that we need to save & invest. The next questions comes into mind is when is the right time to start? Most of us still have too many years to retire so why bother now?

Let's take an example. My friend 'A' starts investing Rs 5000/- every month in a good MF through SIP soon after joining his job when he was 22 years old. He wants to retire at 60 and guess how  much he would have assuming 12% return? Rs 3.66 crore for the investments of about Rs 23 Lakh.

What if he decides to start when he is 40 years old and invests Rs 25000/- every month? Rs 2.16 crore for investment of about Rs 60 Lakh.

What if he starts when he is 50 and invests Rs 100000/- every month? Rs 2.1 crore for investment of about Rs 1.2 crore.

So what is going on here? How come humble Rs 5000/- investment per month over 38 years beats Rs 1 Lakh per month by more than 70%? Let's see what happens in the first scenario. After starting at 22 with Rs 5000/-, when 'A' turns 40 years old, he has already accumulated about Rs 33 Lakh. Hence though this year he invests only Rs 60000, the interest that he gets is whopping Rs 4 Lakh. When he turns 50, his accumulated wealth is Rs 1.1 crore on which he earns interest of Rs 13.2 lakh. That's the magic of compounding my friends.

The simple message is start saving & investing and start as early as possible. Time is running out fast.

Financial planning

Is saving certain amount every month enough? No. That's certainly most important part of financial planning but there is more:

• Life insurance: when you have dependents , it's critical that you have some term insurance with enough sum assured in case something happens to you.
• Health insurance: health insurance too is equally critical as some sudden medical emergency might cripple your finances. Health insurance is actually wealth insurance.
• Emergency funds: you must keep enough money to sustain for 3-6 months in non-risky avenue  like savings account, FD or debt fund for some unforeseen emergency situation like job loss
• Planning for goals: you must have a plan in place for goals like retirement, kids education, buying a house etc
• Estate planning: having a will is really important to ensure that your heirs are not left in legal tangle if something unfortunate happens to you

More on financial planning soon.

Investment avenues

Debt versus Equity

Most of us are generally familiar with debt investment options that include bank accounts, FDs, RDs etc. where rate of interest is fixed and guaranteed. These options are less risky but return too is low.

Equity mean ownership. When you buy shares of some company, you become owner of it and you get proportionate claim on assets and profits. Your investment does well only if company does well and stock market acknowledges it. There is basically no guarantee regarding interest or return. In equity risk is far higher but so are returns.  

I can't stop stressing on the importance of equity and equity investments are critical to beat inflation in the longer term.

What are the different options available for saving & investing money:

1. Bank accounts, FD, RD, NSC, Post office deposits: saving account is good options for keeping money for day to day expenses or emergency funds. However you get hardly 4% interest per year. FD/RD/NSC returns are slightly more but after accounting for tax, they general don't beat inflation.
2. PF, PPF, Tax free bonds: These are promising instruments for long term requirements like retirement planning. Returns are tax free and they generally beat inflation. You can get some tax breaks too.

3. Traditional insurance policies and ULIPs: As I mentioned in my previous articles, these are bad investments and must be avoided at all costs.  More on these in my previous article
4. Real estate: is very popular choices among Indians. Home is basic requirement and generally own house is better than rented one. People however choose to speculate and in the hope for getting rich quick, they end up investing in multiple of them without realizing that not many of them give multibagger returns . Many people prefer to invest in land/plot and commercial properties like office or shops. Real estate is generally good investment avenue but it's highly risky, comparatively illiquid and requires a lot of care to get it right. 
5. Gold: is another very popular choice among Indians. Few years back it gave better returns than equity but this year it didn't perform as good. People believe it's value will always increase in long term but some also say it's a bubble. Gold is again a high risk investment and as per most experts, one should not investment more than 10% of his investments in gold.
6. Shares & trading: These are a very risky and bad options for general public. I see that most people just speculate in share market and do rackless & mindless trading. They seem to make some money during good time but are crushed during bad times. These could be as harmful as buying lotteries and may people end up loosing a lot of money (I am telling this with first hand experience :P). So in short these are very risky with high returns and requires very specialized skills. Hence they should be avoided by most people.  
7. Equity Mutual funds: Mutual funds manage pool of money from multiple people by investing it in shares by dedicated professionals. They are called fund managers and many of them have specialized degree and number of years of experience in share market. It's much easy to invest in these and they are low cost and tax efficient (no tax on if invested for more than one year)..  These are risky with high returns & are critical to beat inflation. Recommended way is to invest regularly in them through monthly systematic investment plans (SIPs).  More details on MFs in my previous article
8. Debt mutual funds: Debt mutual funds invest in corporate deposits which are risker than bank FDs. But again these are managed by professionals hence these are less riskier than corporate deposits. These are also low risk and low (and not guaranteed) return instruments and they hardly beat inflation. These are more tax efficient than FDs (income tax rate applicable is only 10% or 20% with indexation if held for more than one year v/s 30% in case of FDs assuming highest tax bracket). These are good for emergency funds and other similar debt/safe investment requirements.

I hope this article provides a good overview of financial landscape. Please let me know your thoughts, feedback and comments. Also if you liked it, please do share it on facebook/twitter/linked-in and email it to your friends & mail groups.

Further reading:

• The Equity Imperative: by not investing in equities for the long term, too many Indians are setting themselves up for old age poverty
• Time is Everything: the only reliable way of growing your savings at a rate faster than that of inflation is to invest it into equity or equity based investments

Disclaimers and disclosures:

The views shared here are based on my own knowledge and research. Whatever advise I am offering here is best based on my own knowledge & abilities. I would like to reiterate that equity investments are risky and there are no guarantees. However avoiding equity completely is riskier. The risk associated with them can be managed and that's what I am trying to put it across in simplest possible terms. More on this here.

I am not going to get any commissions from any mutual fund etc in case you act on my advice and I don't take any legal responsibility for any losses that you might incur (at the same time not asking you to share your gains with me :P).