Ravi wants to buy a car.
Ravi wants to buy a car which is
worth 5 lakhs in today's price after 2 years.
What is the fundamental
difference between these two statements?
The first statement is simply a
wish, goal or an aspiration. We are not able to process the information further
because of the lack of available data. We have three important inferences, when
it comes to the second statement.
1) The goal of Ravi
2) The current value of the goal
3) Time period that is available to
achieve the goal
These three points are very
important because only knowing these we will be able to predict how much Ravi
has to save today in order to achieve his goal after two years. In other words the
second statement can be termed as a financial goal.
Buying a car, purchasing a house,
education and marriage of children, foreign holiday, retirement - for a middle
class household like us these are the typical and most common goals. Then why
many people are unable to realize their goals?
People are not transforming their goals into financial goals and as a
result they do not know how much to save today in order to realize a goal
tomorrow
Going back to the earlier example
if Ravi wants to buy a car which is worth 5 lakhs in today's price after two
years and considering an yearly increase of 10 percent in the passenger car
segment, the amount he needs at the end of two years will be 500000*(1+0.10)^2
= 605000
So the amount he needs to save
around 23000 per month from today in order to reach his target (assuming a rate
of return of 10%)
Sticking to the traditional mode of investment
Most of us put a lot of effort in
earning money, but put little effort in managing money. Money should work for
us 24*7. Most of us forget this million dollar fact.
While observing the saving
patterns, most of the people in the middle income class bracket save their hard
earned money in the following instruments. Bank FDs, Chit funds, Gold and LIC
policies
Since these types of investments
are considered to be safe investments, the amount of returns they offer will
also be low. So these instruments are unable to generate significant real rates
of returns for the investor.
Let’s examine how the all time favorite
investment vehicles of households done in the past
Bank FDs have given an annualized
return of 8.4 percent in the last 30 years
Gold has given an annualized
return of 10.9 percent in the last 30 years
A satisfactory performance isn’t
it?
But inflation also performed well
during these years. Inflation averaged at 7.5 percent in the last 30 years.
So the real returns (after
adjusting for inflation using the formula ((1+nominal rate)/(1+inflation
rate))-1) for Banks FDs and gold, were 0.83 percent and 3.16 percent
respectively in the last 30 years.
At the end of the day what
matters is the purchasing power and unfortunately gold and FD was not able to
generate that much real returns.
Is there any other financial instrument
that offers superior returns in the long run?
Yes there is – Equity and equity
related instruments
Stock markets have delivered
superior returns in the long run
(I underlined the term long run because investing in stocks means investing in
companies and the growth of the companies will not happen in a single day) compared
to all other financial instruments. When we consider the 30 year annualized
returns of sensex, it has given a return of 20 percent which when adjusted for
inflation is 11.62 percent which is greater than the nominal returns of Bank FD
and gold.
So what we should do in this Diwali?
Some simple but powerful steps
taken in the right direction can have great positive results in the future
Step 1 - Start investments in equities regularly: Investment in
equities can be done either through direct route or through mutual fund route.
For a beginner I recommend mutual fund route, because mutual funds are
professionally managed and invests in a basket of securities. As a result it
can give superior returns in the long term at the same time can limit losses in
the short term also. Investing in mutual funds is one of the best ways to build
long term wealth and the preferred method is through Systematic Investment
Plan. This will bring regularity and disciplined approach in investment. The common
misconception which is prevalent among people is that mutual funds invest only
in stocks. But realty is that mutual funds offers a lot of alternatives to
investors such as equity oriented, debt oriented, hybrid and money market
oriented funds based on investor’s risk appetite and investment horizon.
Step 2 - Please please do not mix your insurance with investment: There are a lot of people investing in various
insurance schemes and unfortunately their primary motive is not insurance but
investment. This attitude needs to be changed. When we buy a car and pays
insurance premium we never asks the insurance company how much will I get after
1 year. But for our insurance we always ask the question what I will get after
the term ends. It is always advisable to go for term insurance and have a clear
demarcation between insurance and investment
Step 3 - Educate the children about the importance of financial savings:
Greatest love of all, the album of Whitney Houston begins by saying children
are our future, teach them well and let them lead the way. Teaching children
the importance of savings and the basics of prudent investment habits can fetch
enormous benefits over a period of time.
Step 4 - Invest for the long run and realize the power of compounding:
All of us will be familiar with the old chess story which is related to the
power of compounding. The moral of the story is that compounding effect can
multiply the wealth several times in the long run. That’s why it is sometimes
referred to as the eighth wonder of the world.
Step 5 - Diversify the savings across different asset class: Throughout
this post I have mentioned the importance of financial goals and building long
term wealth through equity and equity related instruments. Does that mean can I
put all my hard earned savings only in equity? Not at all! Putting all the eggs in one basket is also not an ideal
approach towards investment. One should have a proper portfolio comprising of
equity, fixed deposits, gold and other asset classes. The point is that one
should not ignore one asset class completely.
The savings patterns of people
cannot be changed in a single day. The change will take years to evolve. But if
we can take some steps in this Diwali occasion towards the right direction,
then our life will also be as bright as the lamps that we lighten during this Diwali.
Let this festival season be the
stepping stone towards Financial Independence
On that note Happy Investing J
Views are personal J
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