An investor is someone who commits capital in order to gain financial returns. Warren Buffett, the investment legend, defines investing as “… the process of laying out money now to receive more money in the future.” An investor differs from a trader. An investor puts capital to use for long-term gain, while a trader seeks to generate short-term profits by buying and selling securities repeatedly. Therefore, the frequently asked question is whether an investment is an art or science? Investment is neither an art or nor science; instead, it is common sense based on three important tenets – discipline, patience, and knowledge. An investor must be wary of the market cycle and understand that when he invests, for all the gains that he will make, he will also incur some losses. It is impossible to only gain from the markets and not undergo some loss. However, a seasoned investor will mitigate his losses and increase his gains to ultimately improve his financial position. In this article, we discuss some important facets that an investor must consider while he undertakes his investment journey.
Know Yourself –
There are no set piece solutions for investing or template that fit many or all investors. Each investor is different and before you embark on your investment journey, make sure that you know and understand yourself as an investor. There are some important financial aspects that you must understand and then devise your investment strategy. If you are unable to do it yourself, then seek help from a financial advisor who can help you to do it. First, is to establish your cash flow. If you are a salaried person then financial planning is relatively easier due to fixed cash flow. For a businessperson, it is trickier due to cash flow and business cycle uncertainties. Second, is setting your life’s financial goals that include children education and marriage, house purchase, retirement, dream vacations, and consumer durable among others. In so doing, also decide on the time horizon for each of these goals to then classify them into short, medium, and long-term financial goals. Third, is the aspect of your risk-taking ability that is a function of your age, cash flow and liabilities? This will help you to decide whether you are an aggressive, moderate, or conservative investor. Fourth, beware of venturing into investment options that you do not understand merely because your friend does it or your advisor has asked you to do it for higher returns. Invest only in what you understand and are comfortable to deal with. Fifth, invest in yourself and purchase health/life insurance early in life to keep the premiums low. Normally, one should consider separate family floater policy for health and critical illness coverage and a term insurance policy for life coverage. Ideally, your life coverage should be 10 times your annual salary.
understanding that real returns are the gains made after offsetting the inflation and taxation will help an investor to consider and invest for maximum total returns. Inflation erodes the purchasing power of money e.g. in 30 years, the real value of rupees 100 will become rupees 11.34 at 7 percent annual inflation. The real rate of return is the return adjusted for inflation or other factors. Adjusting the rate of return offers a better measure of investment performance and allows for a more effective risk versus reward measurement. Nominal rates are usually always higher than the real rate of return. Even though fixed deposits guarantee returns, after-tax and inflation deduction, the real rate of returns in these varies between 0.45 to 0.75 percent. Investing in equities is one of the ways to beat inflation as they generate positive real returns over the long-term.
Compounding – Einstein called “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.” Compounding is the process of generating more return on an asset’s reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. See the chart below where we have calculated the yearly compounding of rupees 1 lakh that earns 12 percent annual interest. In 30 years, it has grown to almost rupees 30 lakh. However, it has taken nearly 7 years to double and 21 years to grow 10 times. Thereafter, in the next 10 years it grew from 10 to nearly 30 times of the initial investment. As is evident, the exponential growth of the investment is only in the latter half of the investment period when the investment has grown from nearly 5 to 30 times. Therefore, the investor must start investing early to give himself adequate time for the compounding to work and minimise withdrawals or keep reinvesting the returns.
Flexibility – an investor must always remain flexible in his investments by investing in different types of investments and maintaining a cash reserve to take care of emergencies (emergency fund) or take advantage of investment opportunities. There are many types of investments like mutual funds (open and close-ended), ETFs, individual stocks and bonds, real estate, and various alternative investments. An investor becomes a shareholder or part owner by buying the company shares in dematerialized (Demat) form and thus participates in the company’s growth/decline through rising/fall in share prices. Besides, you also earn dividends that the company gives to its shareholders. Before buying shares, the investor must use his power of observation, artful questioning, and logical deduction to decide on the company. If the investor buys company bonds, then he is loaning money to the company in exchange for periodic interest payments plus the return of the bond’s face amount when the bond matures. Both government and companies issue bonds. Several agencies issue ratings to these bonds to evaluate the probability of whether a bond issuer will default. Some of the important rating agencies are Standard and Poor (S&P), Moody’s, CRISIL, ICRA and CARE. The investor should buy higher-rated bonds, which means the company has fewer chances of default. Government bonds come with the sovereign guarantee and are relatively risk-free. Mutual fund investment is best suited for the passive investor who cannot actively track the market or keep themselves abreast on a day to day basis. These are pooled investments managed by professional fund managers that allow investors to invest their money in stocks, bonds or other investment vehicles as stated in the fund’s prospectus. Mutual funds use the end of trading day Net Asset Value (NAV) for valuation and make distributions in the form of dividends and capital gains based on this. They offer you the advantages of professional management, high liquidity, and more tax-efficient returns. Unlike mutual funds, ETFs (although like mutual funds in many respects) trade constantly, like shares and stocks, while the markets are open. the markets are open.
Diversification – – to diversify means that the investor must invest in various asset classes to manage his risk and earn higher returns. This happens because of the positive performance of some investments neutralizes the negative performance of others. After, diversifying his portfolio into various asset classes like equity, debt, gold, real estate and fixed income instruments, the investor must also consider diversifying within some of the these individually. He can consider buying securities of large, mid, and small market cap companies or let us say mutual funds of different asset management companies or different fixed income instruments like PPF, FDs or SCSS and so on.
Track – after investing, it is equally important to keep track of your investments. Ideally, you should review your portfolio on a half-yearly basis and if this is asking too much then at least once a year is necessary. The portfolio review will indicate the gainers and losers in the portfolio, the financial instrument’s performance in relation to its financial goal and the overall growth of the portfolio. Having reviewed the portfolio, the investor must then rebalance his portfolio. In so doing, he must shed his losers, switch, or reinvest in other asset classes to maximise gains and offset losses and realign his portfolio with his financial goals.
Technology – like all other facets of life, technological advancement also has a significant impact on investors. The digitization of the bourses and concomitant dematerialization of securities has eased the investment avenues for investors. It has facilitated research and analysis by investors by opening the plethora of information and tutorials on the net, generated options for them to invest in various financial instruments and significantly reduced paperwork by facilitating investment through the click of a button. The next big change is the introduction of Robo-advisory services, which use technology for client portfolio management by using algorithms. All these have eased out investor apprehensions and reduced tariffs and fees.
Emotions – there is no place for emotions in investments. An investor should be aware of the fear of loss or regret, greed, risk aversion and bandwagon effect during his investment. An investor should hold his stocks or other investments dispassionately and consider their purchase or sale objectively. He should shed them when they have delivered the result, stopped giving profit or outlived their utility. One can not make an investment for an indefinite period; relate it to a financial goal or investment horizon. Prudent investment is to the use of financial assets that are suitable for your financial goals and objectives by considering the risk/return profile and the available time horizon. To do this, you must keep the fees and taxation minimized, and rebalance the portfolio periodically.
Markets – know that markets are volatile in the short-term. As the investment horizon increases, the probability of loss reduces. Sensex movement in the last 39 years has proved that the likelihood of losing money for periods of 15 years or more has been zero. Since 1979 till date, markets have given a CAGR of 17.1%. If wealth compounds at this rate, then an investment in the stock market doubles every 4.5 years. Robert Kiyosaki had suggested, “it is not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” If an investor stays fully invested in the market then he will earn a lucrative CAGR that beats volatility and inflation. However, if he tries to time the market, then he runs the risk of missing days that registered some of the biggest gains and the CAGR will drop drastically.
Discipline – a disciplined approach in investment by taking the SIP/SEP route to help you to beat the market volatility, achieve rupee cost average and reach your financial goal faster. Since the early bird catches the worm, prudence lies in starting as early in life as possible. Elders can inculcate the habit in their children by making them save small amounts from their pocket money that they give them during school or college days. Let us exemplify this with the case of two investors – Mr. Wise and Mr. Unwise. Both investors invest rupees 36 lakh over different time spans of their life. Mr. Wise invests rupees 10,000/- per month from the age of 25 to 55 years, whereas Mr. Unwise invests rupees 15,000 per month from 35 to 55 years. At the end of their investment period, Mr. Wise’s investment grows to rupees 7.01 crore, but that of Mr. Unwise grows to only rupees 2.27 crore – a shortfall of rupees 4.74 crore. There is no dearth of financial calculators or ready reckoners, available on the internet, which show the exponential growth of your wealth through the SIP route. Another aspect that an investor must consider is to increase the SIP amount by 10 or 15 percent every year. Evident from the table below is the fact that if an investor tops up or increases his SIP of rupees 10,000 by 10 percent every year, then his corpus at the end of 30 years will be 150 percent more.
Taxation – since taxation is a dynamic process and undergoes changes frequently an investor must keep himself abreast with the taxation policy of his country. This will help him to invest in tax-efficient financial instruments that will also assist in simultaneous wealth creation. In our country, government levies tax on your income through stipulated income tax slabs. Government considers your annual interest income from various fixed income instruments as part of your income and taxes them as per your IT slab. Additionally, it also levies varying capital gains tax on your equity and debt instruments and taxes them based on you holding duration (short-term if you hold equity for less than one year and debt for less than 3 years, and long-term if you hold both for periods more than their short-term duration respectively). Capital gains harvesting or setting off capital losses are some of the means to reduce taxation legally, provided you reinvest the capital to maintain the corpus. Equity Linked Savings Scheme (ELSS) investment in mutual funds with a 3-year lock-in period, provides lowest lock-in period and tax efficient returns with tax savings under Sec 80C of the IT Act.