Long-term investments allow power of compounding to work

Short-term needs require that money should be liquid and safe, whereas long-term needs require low liquidity and allow the investor to take more risk


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I have just moved to a new job with a 50% pay hike. But my expenses remain about the same, Rs.40,000 a month. I have investments in equity mutual funds—Rs.10,000 a month via systematic investment plans (SIP)—and Rs.1 lakh total in direct equities. Should I increase my investments in mutual funds or equities? I have money in Public Provident Fund (PPF) and Rs.1 lakh in a fixed deposit (FD). What percentage of the raise can I invest without taking on too much risk?

—Hansal Parekh

Let’s start with how much you can increase your investments. A salary increase of 50% and with no or marginal increase in expenses should make you put your money to good use and increase your investments with the entire salary increment net of taxes. The rationale is that the increased salary amount will otherwise remain in a savings account and not be invested as the expenditure more or less remains the same. Not only is it not prudent to leave money in a savings account, you may even find your expenses going up at some point due to easy availability of funds.

Also, you need to be clear that all investment does not translate into risk. Allocate assets to distribute investments as low-, medium- and high-risk. For example, investments in PPF and FD will come under the low-risk category. Investments in balanced funds that have equity exposure of around 65% are medium-risk, and investments in equity funds and stocks are high-risk. Within the equity assets also, risk can be classified based on exposure in large cap, mid cap and small cap.

The key is to follow a strategy based on needs. Short-term needs require that money should be liquid and safe, whereas long-term needs require low liquidity and allow the investor to take more risk. The advantage of long-term investments, besides targeting a higher return, is the benefit of power of compounding. This can help in creating wealth over a longer period. But this means planning and patience.

Within the choice stocks and equity mutual funds, preference should be given to equity funds. These offer you diversification, risk reduction, professional management, convenience to buy and sell and transparency.

Based on the above, you can create an asset allocation with a combination of equity mutual funds along with debt assets like PPF and debt mutual funds. In most mutual funds, you can start investing via SIPs. You can invest systematically in PPF as well.

Direct equity is also one way of investing. However, you need to study the companies carefully before investing in their stocks. In direst equity, too, make long-term investments rather than choosing to go for short-term trading. This requires you to have adequate knowledge about the companies, which means doing considerable amount of research. The risk quotient is the highest in case of direct stocks.

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