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Chapter 1
Chapter 2
Chapter
3
Chapter 4
Chapter 5
Chapter 6
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Have you
ever wished you could give up your job to live life on your own terms,
without having any money troubles? Do you find that your expenses increase
by geometric progression, while your yearly raise and bonus increases by
arithmetic progression?
Do you
find it unfair that the rich seem to grow richer almost effortlessly,
while most of us ordinary folk struggle to save even meagre amounts?
If you
answered ‘Yes’ to any of these questions, then it’s time to re-think your
savings and investment strategy. Investing is not about parking a little
money in the bank every few months. It may not be rocket science; but it’s
no cake walk either. A good investment strategy needs both, time and
money.
Why invest?
Until a few years ago, it was common for people to stay in the same job
all their working lives. But today, unlike in a cushy government job,
where one gets pension that has a dearness allowance built in (to take
some of the bite off inflation), most people work in the private sector,
without any guaranteed job security. Thus, the only way to secure old age
is to invest now, when one is young and capable of earning.
For the
‘sandwich’ generation, i.e., the ones who look after their aged parents
and take care of their children’s needs today, but can’t depend upon their
children to look after them in their old age, it’s all the more critical
that they make the most of their earning years and invest for their future
needs. If that sounds intimidating, take heart. All you need to get
started is a primer on investing. That’s what this book is about.
To begin, investment is all about making your money earn
you more money. Simply put, it is the practice of making your money work
for you, rather than you working for your money.
Understanding cash flow
When you examine the various entries in your bank statements, you will
find that the credits into your account come from one or more of the
following sources:
- Salary,
- Business and
- Investment income (interest, dividends, etc.)
Now let’s look at where your hard earned money vanishes each month:
- Expenses
- Essentials (house rent, utility payments, food,
and clothing)
- Non-essentials (the new flat screen television,
the designer bag or perfume, the latest mobile or other forms of
consumption expenditure)
- Taxes, over which most salaried people have little
control; and
- Investments (money spent in obtaining insurance,
stocks, bonds, mutual funds, fixed deposits, etc.), which, unfortunately
comes last in the order of priority for most people.
the
secret to getting rich is to pay yourself first (i.e., invest for your
future), before you pay others (utilities, shops, etc).
Investments must, hence, be foremost in the order of priority barring any
financial emergency. That way, you’re sure of saving a particular amount
each month; in addition, it may also encourage you to limit your spends
within your means.
Where to invest?
There are so many different investment avenues such as stocks, mutual
funds, government bonds, post office schemes, bank fixed deposits,
commodities, gold, real estate, art etc., that a regular person might be
scared of the whole exercise. If your usual investment strategy is to dash
off to the local bank and put your money into a fixed deposit (FD), then
it’s time to re-think. There’s nothing wrong with FDs. They are time
tested, safe, and in the current interest rate scenario, also attractive.
However, if your aim is to create wealth to achieve short-term and long
term financial goals (foreign vacation, children’s education and marriage,
retirement and so on), FDs lag sadly behind other forms of investment.
Although banks may appear to offer attractive interest rates on FDs, the
fact is that they often fail to keep up with inflation.
Inflation
You have heard about it, but do you really know what it means? Inflation
is the rate at which the cost of goods and services rises. Simply put, as
inflation goes up, your purchasing power decreases. Much like what is
happening in the real estate sector now. As real estate prices and
interest rates on loans increase, buyers are forced to consider smaller
houses in far flung localities. Three years ago, you could have bought a
three bedroom apartment in a premium suburb of Mumbai for Rs 75 lakh;
today, the same amount will probably get you a one bedroom apartment in
the same locality! Thus, your purchasing power has reduced. That’s exactly
what inflation does to your savings over time – it reduces the value of
your money.
Impact of inflation on financial goals
This simply means that over the years, you have to spend more in order to
maintain your standard of living. What about other expenses like
retirement and planning for your children’s higher education? Well,
obviously, those will cost dramatically more too. A management course that
costs Rs 15 lakh today will cost around Rs 41 lakh (at 7 per cent
inflation), 15 years hence when your child is ready for it!
In order to meet that expense after 15 years, you will have to block more
than Rs 11 lakh today in an FD @ 9%. If you take into account taxation,
this figure will be even higher. Hence, even if FDs may marginally beat
inflation, this is clearly not enough in the long run, especially for
salaried individuals.
The following table shows the comparative cost of certain life goals now,
and the expected cost after 15 and 20 years, assuming an inflation rate of
7 per cent.
Real return
Can you beat inflation? Definitely, but putting your money in a FD is not
the way to go about it. To fight inflation, you must invest in a product
which gives you not just a higher rate of interest than inflation, but
also leaves you with a substantial amount that enables you to meet your
goals. If not, you will find that the value of your investment has
actually reduced! Shocked? Let’s see why this happens.
An investment that offers a return of 10 per cent per annum sounds quite
good. But are you really going to earn so much? The answer is ‘No’. You
have to factor in inflation to find out your actual earnings. This is
called the “real return”. To calculate the real return, you need to
subtract the rate of inflation from the stated return. So, assuming an
inflation rate of 7 per cent, your real return will be 10 – 7 = 3 per
cent.
In addition, if you take into account the tax implications, the real
return might be even lower. A 30 per cent tax on your 10 per cent interest
income would knock off 3 per cent, which is your real return. That doesn’t
sound as good, does it? So the next time you have money to invest, keep in
mind the real return, and not the advertised one. Thus, you might consider
investments such as equities, real estate, and commodities which are
relatively insured from inflation, as compared to FDs.
Accelerate your earnings: The concept of reinvestment
It’s rather simple to make your money work for you. Do you spend the
interest you earn on FDs or do you invest it in another avenue, i.e.,
reinvest it? The simple act of reinvesting the interest earned means you
earn interest on the interest and make more money. Isn’t that making your
money work for you?
Suppose you invested a sum of Rs 2 lakh in the Post Office Monthly Income
Scheme (MIS) @ 8 per cent per annum. Every month, a sum of Rs 1,333 will
be deposited into your savings account, for a period of 6 years. “Where
should i invest such a small amount?”, you may ask. Well, the Department
of Posts has a Recurring Deposit (RD) scheme, where you can invest as
little as Rs 10 each month @ 8 per cent per annum. Your MIS interest over
5 years would be Rs 80,000. Reinvesting would, hence, earn you an
additional interest of 8 per cent on the Rs 80,000, without much effort.
Investment avenues such as equities and mutual funds often have a much
higher rate of return than FDs and MIS. Imagine how much more you can
reinvest. Another advantage of reinvesting is that it can help you reach
your financial goals faster.
The following example demonstrates how reinvestment over a longer time
period can boost your income. Anita and Sunita are 25 years old. Anita
invests Rs 10,000 @ 7 per cent (compounded annually) today. Ten years
later, Sunita decided she would like to do the same. When they turn 60,
they decide to see how much money they have earned.
Anita’s Rs 10,000 grows to Rs 1,06,765.81, while Sunita’s Rs 10,000 grows
to only Rs 54,274.32! How can the difference be so vast considering that
both invested the same amount of money at the same interest rate? The
answer is time. Anita begins 10 years earlier and thus earns more
interest, which is reinvested, and consequently helps her investment grow
exponentially.
Hence, your investment needs time and reinvestment of the interest,
dividends, and other profits that you get from your original investment.
Further, the longer you reinvest your interest income, the higher your
original investment grows, and the faster you reach your financial goals.
That means, if you plan to save for your retirement, the earlier you begin
the lesser you will have to invest to build a bigger nest egg.
The following table demonstrates the value of Rs 10,000 invested at 7 per
cent over a period of 35 years, assuming that the interest is reinvested.
The power of compounding
What exactly is the power of compounding and how can a regular person use
it to his or her advantage? Well, to begin with, it goes hand in hand with
the concept of reinvestment. Every time you reinvest your income from
interest on investments, your capital or principal that is invested goes
up. The next time you earn interest, it is on this enhanced capital, and
is therefore higher than what you would have received if you chose not to
reinvest. Over a period of time, these small extra amounts can add up to a
tidy sum. In fact, Albert Einstein, once called compounding the greatest
mathematical discovery ever.
Apart from time, another factor that influences compounding is the
frequency of compounding. You’ve probably heard of investments that offer
monthly, quarterly and annual compounding. The shorter the compounding
frequency, the more interest you earn, the more interest you reinvest, and
the faster your money grows.
Taking
our previous example of a person saving for his son’s management
education, instead of blocking more than Rs 11 lakh today in a FD, he
would need to invest approximately Rs 10,900 per month if an RD is
available @ 9% (compounded monthly), which is nearly the same as his
monthly savings of Rs 10,000. Thus the frequency of compounding has a
crucial role to play in investment planning.
The following table demonstrates the effect of compounding across
different frequencies, for a sum of Rs 10,000 @ 9 per cent per annum for
10 years.
Thus, after 10 years, the investment which was compounded monthly grew by
almost Rs 1000 more, than the investment which was compounded annually.
Compounding is such a powerful financial tool that if you invest and
reinvest your savings and profits regularly, your investment portfolio
will steadily outgrow your salary!
Now that you have understood the basic tenets of cash flows, inflation and
compounding, let’s understand financial planning and its need.
Chapter 2
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