Investing Basics
Wise investing requires knowledge of key financial concepts and an understanding of your personal investment profile and how these work together to impact investing decisions. Here we will understand the difference between saving and investing. Illustrate the risk/rate-of-return tradeoff, the importance of the time-value of money and asset allocation, your personal risk tolerance, recognize your financial goals and in defining an appropriate investment plan and asset mix for you and your family
The Difference between Saving and Investing
Even though the words "saving" and "investing" are often used interchangeably, there are differences between the two.
Saving provides funds for emergencies and for making specific purchases in the relatively near future (usually three years or less). Safety of the principal and liquidity of the funds (ease of converting to cash) are important aspects of savings Rupeess. Because of these characteristics, savings Rupeess generally yield a low rate of return and do not maintain purchasing power.
Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk (of loss of principal) and is to be considered only after you have adequate savings.
| Savings vs. Investment Rupeess |
| Savings Rs. |
Investment Rs. |
| Safe |
Involve risk |
| Easily accessible |
Volatile in short time periods |
| Low return |
Offer potential appreciation |
| Used for short-term goals |
For mid- & long-term goals |
Investment Return
Total return is the profit (or loss) on an investment. It is a combination of current income (cash received from interest, dividends, etc.) and capital gains or losses (the change in value of the investment between the time you bought and sold it). The published
rate of return for a selected investment is usually expressed as a percentage of the current price on an annual basis. However, the
real rate of return is the rate of return earned after inflation, which is further reduced by income taxes and transaction costs.
| Illustration of "Total Return" and "Rate of Return" |
| Example: |
Current Income |
+ Capital Gain (or loss) |
= Total RETURN |
| Rs.2 |
+ Rs.1 |
= Rs.3 |
| Example: |
Annual return |
÷ Current price of security |
= Rate Of RETURN |
| Rs.3 |
÷ Rs.24 (per share) |
= .125 or 12.5% |
Understanding Risk
All investments involve some risk because the future value of an investment is never certain. Risk, simply stated, is the possibility that the ACTUAL return on an investment will vary from the expected return or that the initial principal will decline in value. Risk implies the possibility of loss on your investment.
Factors which affect the risk level of an investment include:
 |
Inflation |
|
Business failure |
|
Changes in the economy |
|
Interest rate changes. |
The Risk / Rate-Of-Return Relationship
Generally speaking, risk and rate of return are directly related. As the risk level of an investment increases, the potential return usually increases as well. The pyramid of investment risk (Figure 2) illustrates the risk and return associated with various types of investment options. As investors move up the pyramid, they incur a greater risk of loss of principal along with the potential for higher returns.
 |
Pyramid of Investment Risk |
Diversification
You can do several things to offset the impact of some types of risk. Diversifying your investment portfolio by selecting a variety of securities is one frequently used strategy. Done properly, diversification can reduce about 70% of the total risk of investing. Think about it. If you put all of your money in one place, your return will depend solely on the performance of that one investment. Alternatively, if you invest in several assets, your return will depend on an average of your various investment returns. Here are three basic ways to diversify your investments:
|
By choosing securities from a variety of asset classes, e.g. a mix of stock, bonds, cash and real estate |
|
By choosing a variety of securities or funds within one asset class, e.g. stocks from large, medium, small and international companies in different industries |
|
By choosing a variety of maturity dates for fixed-income (bond) investments. |
|
By diversifying, you won’t lose as much as if you invested in just one security right before its market value goes down. However, if the market goes straight up from the time you started, you won’t make as much in a diversified portfolio either. However, historically, most people are concerned about protection from dramatic losses. |
Rupee-Cost Averaging
Another technique to help soften the impact of fluctuations in the investment market is Rupee-cost averaging. You invest a set amount of money on a regular basis over a long period of time—regardless of the price per share of the investment. In doing so, you purchase more shares when the price per share is down and fewer shares when the market is high. As a result, you will acquire most of the shares at a below-average cost per share.
Look at the Rupees-cost averaging illustration below. One hundred Rupeess is invested each month. Due to fluctuations in the market, the number of shares purchased with the Rs.100 each month varies, because the shares vary in price from Rs.5 to Rs.10. You can see that, when the share price is down, you acquire more shares as in months 2, 3, and 4. You benefit when/if the price per share goes up.
| Rupees-Cost Averaging Illustration |
| |
Regular Investment |
Share Price |
Shares Acquired |
| Month 1 |
100 |
10.00 |
10.0 |
| Month 2 |
100 |
7.50 |
13.3 |
| Month 3 |
100 |
5.00 |
20.0 |
| Month 4 |
100 |
7.50 |
13.3 |
| Month 5 |
100 |
10.00 |
10.0 |
| Total |
500 |
|
66.6 |
| Your Average Share Cost: 500 ÷ 66.6 = 7.50 |
As most investors know, market timing . . . always buying low and selling high . . . is very hard to accomplish. Rupee-cost averaging takes much of the emotion and guesswork out of investing. Profits will accelerate when investment market prices rise. At the same time, losses will be limited during times of declining prices. For most people, Rupees-cost averaging is not so much a way of making extra money as a way to limit risk.
The Time- Value Of Money
Now that you understand the concepts of risk and return, let’s turn to an element that is at the heart and soul of building wealth and financial security...TIME.
| Here is how time can work for you: |
| 1. |
The longer you invest, the more money you will accumulate. |
| 2. |
The more money you invest, the more it will accumulate because of the magic of compound interest. |
| Compounding works like this . . . |
The interest earned on your investments is reinvested or left on deposit. At the next calculation, interest is earned on the original principal PLUS the reinvested interest. Earning interest on accumulated interest over time generates more and more money. |
Compounding also applies to dividends and capital gains on investments when they are reinvested. The following illustration and questions give you a first-hand opportunity to calculate the impact of time on the value of your investment accumulation. Please complete the exercise below before moving ahead to the next section.
How Time Affects The Value Of Money
Investor A invests Rs.2,000 a year for 10 years, beginning at age 25. Investor B waits 10 years, then invests Rs.2,000 a year for 31 years. Compare the total contributions and the total value at retirement of the two investments. This example assumes a 9 percent fixed rate of return, compounded monthly. All interest is left in the account to allow interest to be earned on interest.
| Age |
Years |
Investor A |
Investor B |
| Contributions |
Year End Value |
Contributions |
Year End Value |
| 25 |
1 |
2,000 |
2,188 |
0 |
0 |
| 26 |
2 |
2,000 |
4,580 |
0 |
0 |
| 27 |
3 |
2,000 |
7,198 |
0 |
0 |
| 28 |
4 |
2,000 |
10,061 |
0 |
0 |
| 29 |
5 |
2,000 |
13,192 |
0 |
0 |
| 30 |
6 |
2,000 |
16,617 |
0 |
0 |
| 31 |
7 |
2,000 |
20,363 |
0 |
0 |
| 32 |
8 |
2,000 |
24,461 |
0 |
0 |
| 33 |
9 |
2,000 |
28,944 |
0 |
0 |
| 34 |
10 |
2,000 |
33,846 |
0 |
0 |
| 35 |
11 |
0 |
37,021 |
2,000 |
2,188 |
| 36 |
12 |
0 |
40,494 |
2,000 |
4,580 |
| 37 |
13 |
0 |
44,293 |
2,000 |
7,198 |
| 38 |
14 |
0 |
48,448 |
2,000 |
10,061 |
| 39 |
15 |
0 |
52,992 |
2,000 |
13,192 |
| 40 |
16 |
0 |
57,963 |
2,000 |
16,617 |
| 41 |
17 |
0 |
63,401 |
2,000 |
20,363 |
| 42 |
18 |
0 |
69,348 |
2,000 |
24,461 |
| 43 |
19 |
0 |
75,854 |
2,000 |
28,944 |
| 44 |
20 |
0 |
82,969 |
2,000 |
33,846 |
| 45 |
21 |
0 |
90,752 |
2,000 |
39,209 |
| 46 |
22 |
0 |
99,265 |
2,000 |
45,075 |
| 47 |
23 |
0 |
108,577 |
2,000 |
51,490 |
| 48 |
24 |
0 |
118,763 |
2,000 |
58,508 |
| 49 |
25 |
0 |
129,903 |
2,000 |
66,184 |
| 50 |
26 |
0 |
142,089 |
2,000 |
74,580 |
| 51 |
27 |
0 |
155,418 |
2,000 |
83,764 |
| 52 |
28 |
0 |
169,997 |
2,000 |
93,809 |
| 53 |
29 |
0 |
185,944 |
2,000 |
104,797 |
| 54 |
30 |
0 |
203,387 |
2,000 |
116,815 |
| 55 |
31 |
0 |
222,466 |
2,000 |
129,961 |
| 56 |
32 |
0 |
243,335 |
2,000 |
144,340 |
| 57 |
33 |
0 |
266,162 |
2,000 |
160,068 |
| 58 |
34 |
0 |
291,129 |
2,000 |
177,271 |
| 59 |
35 |
0 |
318,439 |
2,000 |
196,088 |
| 60 |
36 |
0 |
348,311 |
2,000 |
216,670 |
| 61 |
37 |
0 |
380,985 |
2,000 |
239,182 |
| 62 |
38 |
0 |
416,724 |
2,000 |
263,807 |
| 63 |
39 |
0 |
455,816 |
2,000 |
290,741 |
| 64 |
40 |
0 |
498,574 |
2,000 |
320,202 |
| 65 |
41 |
0 |
545,344 |
2,000 |
352,427 |
| Value at Retirement |
Rs.545,344 |
|
Rs.352,427 |
| Less Total Contributions |
(Rs.20,000) |
|
(Rs.62,000) |
| Net Earnings |
Rs.525,344 |
|
Rs.290,427 |
Using the data for investors A & B, answer the following questions.
Note: that Investor A, who invested much less than Investor B, has a much higher nest egg at retirement age, because of a 10-year head start. As you can see from this example, compound interest is especially magical when money is steadily invested and left to grow over a long period.
Asset Allocation
Your overall investment return will be closely associated with the asset categories and allocations that you select. An investor’s group of investments, frequently called an investment portfolio, can be divided in numerous ways among stocks, bonds and cash management options. You might choose a 20/40/40 portfolio . . .20% stocks, 40% bonds and 40% cash options. Or. a 75/20/5 ratio . . . 75% stocks, 20% bonds, and 5% cash.
Several factors will impact the exact rate of return that you receive on your investment portfolio. Studies show that the most important one, asset allocation, will account for about 90% of your return. The selection of individual securities and market timing will account for the remaining 10% or so.
The critical question, of course, is: "What is the ideal asset allocation for you?" Here are several factors to consider as you make this decision.
Your Ideal Asset Allocation will be Influenced by Your . . .
|
Investment Goals |
|
Risk Tolerance |
|
Time Horizon |
|
Tax Situation |
|
Time & Skill to Manage Portfolio |
Your Investment Goals
Goals are specific things (e.g., buy a house, children’s education etc) that people want to do with their money. As people move through various life stages, their needs and financial goals change. Your selection of investments should relate closely to your financial goals; each goal will define the amount and liquidity of the money needed as well as the number of years available for the investment to grow.
Your Risk Tolerance
Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investment market without panicking when the value of investments goes down. Risk tolerances vary widely. Some are associated with personality factors, while others are based on changing needs dictated by your stage in the life cycle. If you won’t sleep well at night when the principal value of your investment goes down, you should select saving and investment options with lower risk. On the other hand, it’s important to realize that investments which guarantee the safety of principal will not grow your money quickly and may not maintain purchasing power in times of inflation or over a long time span. In reality it’s necessary to take some risk just to maintain purchasing power. The question is: "What kind of risks are you willing to take?"
Your Time Horizon
Time is a very important resource to investors. For example, young investors with a long time horizon may choose investments that exhibit wide price swings, knowing that time is available for fluctuations to average out. Families investing for a specific mid-life goal (e.g., funding a child’s education or purchasing a home) may choose a more moderate course which has opportunity for growth, but provides more safety for the principal. Individuals nearing retirement and those with the need to depend on investment income to cover daily expenses, may wish to select investments that lock in gains and provide a guaranteed income stream.
Your Tax Situation
The return on any investment is influenced by your tax situation. Before selecting an investment, learn its tax consequences for you. Remember, what counts is not what you make on an investment, but what you get to keep both now and in the long run.
Time and Skill to Manage Your Portfolio
Some investments require little or no time commitment or special knowledge. Others, such as rental property, or a portfolio of high-risk individual stocks may require constant monitoring and management. How much time are you willing and able to spend?
In a nutshell, the asset allocation which you select must be customized to your situation, needs and temperament. Spend a few minutes completing the "What are Your Investment Preferences" exercise to help you further clarify and summarize your investing preferences.
What are Your Investment Preferences?
Consider each pair of words below as a continuum. Place an "x" on each line of the continuum to indicate how important each of these features is to you. Marking the middle of a line would therefore mean that the features were of equal importance.
| Low risk (Safety) |
High-risk |
| Low rate of return |
High rate of return |
| Low capital growth |
High capital growth |
| High capital preservation |
Low capital preservation |
| Not very liquid |
Highly liquid |
| Short-term maturity |
Long-term maturity |
| Taxable |
Tax-exempt |
| No minimum investment |
High minimum investment |
| Low costs and fees |
High costs and fees |
| Little or no management required |
Much management required |
| Present income |
Capital growth |
| Conservative |
Aggressive |
If others are sharing investment responsibility with you, ask them to complete it as well.
|
Review your responses carefully. |
|
Check for inconsistencies in the preferences you have indicated. (For example, do you prefer things that are unlikely to come together, e.g., low risk and high return?) |
|
Work to understand and resolve inconsistencies and differences in order to assure that your overall investment strategies and asset allocation are consistent with both your needs and your preferences. |
