In the last post we had a cursory view of Protection. We now move to the world of investments. As I had indicated in my previous blog, most financial investments would fall into the following broad Categories Debt or Equity. There are so many choices to make and hence it may be a good idea to establish a simple framework that you can use while making your investment decisions. This is what I use personally and I do believe that you would find it useful too!
First, Do you understand what you are buying?
Often, many of us end up buying financial products that we do not understand at all. Eureka! Someone gave you a tip to invest in a particular stock. Do you really understand why that tip would work in the first place? If not, why invest? We hear a lot of tragic stories of investors who have lost lots of money because they could not understand why they were investing in the first place? They take the advice being provided on face value and they hardly apply any meaningful logic before making their investment decision. In several cases, you end up buying a product because your colleague, neighbour or your friend bought the same. Many of these investments are done because of greed or fear. There is a lot of literature in the investment world now which acknowledges that there are a lot of psychological barriers that come in your way of becoming a good investors. These apply to all investment professionals as well. I will not dwell into this subject now but try and build a framework that you can use and work with right away.
Two rules that have worked well for me are:
(a) Start Small with financial products that you do not understand. Invest a very small portion. Make a sample investment. In this way you can start building your own experiences and hopefully over a period of time you will build familiarity with the investment and who knows you may actually become an expert at it some day. If you do not experiment how would you really learn? Never take a large exposure to something that you do not understand.
(b) Ask this question always. What is reason or purpose or expectation for making the investment? You could describe your reasons in many ways – for example you want to save for your retirement or use the money to buy a house or want to save for your children’s education or marriage or just some financial security? Or you want to get regular income in your retirement years or there is a short term surplus that you have and would like to earn something on the same.
From a financial perspective, we generally segregate all reasons for investing into the following three categories.
(1) Wealth Preservation: The primary requirement for the investor is to safeguard the principal at all costs. You are not willing to take any risk that could erode your principal. For example you have some money/surplus with you and you do not expect to use it for the next few days or a few months. Safety is your biggest requirement and returns are secondary.
(2) Regular Income: The primary requirement here is that you would like to get some regular income with minimum of risk to your principal. Most retirees would have an investment need of generating regular income from the savings that they have made during their lifetime. Of course, they would not want to take significant risks while making their investments. Most of them, do not want to take any risk at all!
(3) Wealth Creation: Here your primary goal is to generate a higher returns for yourself. You may or may not be willing to take risks for the same. Unfortunately, there is no free lunch. If you genuinely want to gain wealth, you will have to take some risks. The good news, however, is that certain investments may appear very risky in the short run but have a huge chance of working out in the long run.
Let us now put the above two questions together and see what the real world has to offer in these categories:
Investment Objective: Wealth Preservation: You can achieve this objective by simply leaving your money in your Bank or Post Office savings account or buying a short term Bank Fixed Deposit or investing in liquid funds.
Investment Objective: Regular Income: Traditionally investors have achieved this objective by investing in Bank Fixed Deposits with maturities of 1 year or above. You can also invest in company fixed deposits, Post Office Monthly Income Schemes and other debt instruments that provide income at regular intervals. You can also use Income Funds (most of these mutual fund products that are termed as income or Debt funds invest 100% of the money in Fixed Income instruments. However a few categories of Debt funds do take a little exposure to equities).
Investment Objective: Wealth Creation: Traditionally a lot of investments are made in Debt instruments like Cumulative Bank Deposits (Interest gets reinvested in the deposit and is not paid out), Public Provident Fund (PPF), National Savings Certificates, Senior Citizen Savings Scheme Accounts etc. However, you could invest into Equity Funds (mutual fund products that invest predominantly into equities and come by a variety of names like xyz large cap Fund or abc Equity Fund etc.). You could also own some stocks directly by opening a Demat and Broking account. Nowadays Systematic Investment Plans (SIP) has gained a lot of popularity amongst investors with several investors investing a fixed amount at periodic intervals into equity funds.
At this point, we have established some linkage between your investment goals and investment products that could help you meet these investment goals. You would also have realised that you have a good understanding of some of the investment avenues while you have very little understanding of a few others. Remember the first rule that if you do not understand you start with a little investment!
It does not always pay to be brave in the world of investments! The two reasons why many of us fail is that either we invest too much with too little understanding or we do not invest at all. Both extremes need to be avoided.
In my next blog, we will set up a basic investment framework. The idea is to help you ask the right set of questions before making your investment decision. This would obviously help you achieve a better understanding of your investments. As you use this framework, it will be become a habit to ask the right set of questions. This is critical to manage your money better.
