Most people can solve complex mathematical problems with ease but struggle when it comes to understanding investments and financial goals. One can partially blame this on our formal education system which completely ignores the topic of personal finance, even though it is one of the major causes of stress in most people’s lives.
Here are some concepts which can help the first-time investor:
Inflation, financial goals and planning
Look 20 years back. Try to imagine what the cost of schooling, college fees, cost of movie ticket, price of milk was and look at the same now. The costs have increased manifold. Inflation is a silent killer; prices gradually keep moving up and making a hole in our pockets. The first reason why one needs to invest is to beat inflation. The first step any first time investor should start with is by writing down their financial goals. One can divide their goals into short-term ones (1–3 years), medium-term (3–7 years) and long-term (over 10 years).
It is the most important and often the most ignored financial goal. Life can be divided in 3 phases — the first phase is the learning phase of 25 years where we are dependent on our parents financially, the second phase is the one where we earn and accumulate money — from 25 years to 55 years (approx. 30 years). This is followed by the retirement phase from 55 years to 85 years or more (approx. 30 years). One should start saving and investing from an early age for retirement.
Equity and fixed income
Once we have written our goals, the next step is about the tools to achieve these goals. There are two asset classes which one can use to reach their financial destination–equity and fixed income (also called debt). The ease of investing makes mutual fund a good option for investors. Risk and returns are the two sides of the same coin. Equity has potential to give high returns and create wealth over a longer period of time which is one half of the story; the other half is that the returns of equity are also very volatile. If one is looking to invest in equity mutual funds, the horizon should be at least more than 10 years. Returns of fixed income are moderate, but it is also safe and predictable.
Importance of time
The simple formula of compounding taught in primary school has the power to help us create wealth: future value = present value (1+ returns) ^ time. The future value is dependent on how much you invest which is present value , what returns the investments generate and the time given. Most of us focus only on returns, but if one looks at the formula closely, the exponential value in the formula is time.
Also, one should decide the allocation of equity and fixed income based on one’s financial goals and risk-taking ability. You should also invest in a disciplined way which you can do via systematic investment plans.
We are surrounded with temptations — it’s difficult to save and invest in a world where desires increase at a much faster pace than earnings and investing.
The allocation in equity should be based on financial goals and one’s risk appetite, but it’s often seen that when equity markets give high returns, investors get caught up and allocate more money in equity markets.
Similarly when markets fall, the emotion of fear takes over and investors panic and remove money from equity markets at a loss.
Lastly, we all need a coach and guidance for everything we do. Having a good trusted financial advisor can make life much simpler when it comes to investing and achieving one’s financial goals.
Kalpen Parekh, president of DSP Investment