The Need to Invest

Before we address the above question, let us understand what would happen if one chooses not to invest. Let us assume you earn Rs.50,000/- per month, and you spend Rs.30,000/-towards your cost of living, which includes housing, food, transport, shopping, medical, etc. The balance of Rs.20,000/- is your monthly surplus. For the sake of simplicity, let us ignore the effect of personal income tax in this discussion.

To drive the point across, let us make a few simple assumptions.

1. The employer is kind enough to give you a 10% salary hike every year.
2. The cost of living is likely to go up by 8% year on year.
3. You are 30 years old and plan to retire at 50. This leaves you with 20 more years to earn
4. You don’t intend to work after you retire.
5. Your expenses are fixed and don’t foresee any other expense.
6.  The balance cash of Rs.20,000/- per month is retained in the form of hard cash.

Going by these assumptions, here is how the cash balance will look like in 20 years.

If one were to analyze these numbers, you would soon realize this is a scary situation to be in. Few things are quite startling from the above calculations:

1. After 20 years of hard work you have accumulated Rs.1.7Crs.
2. Since your expenses are fixed, your lifestyle has not changed over the years, you probably even suppressed your lifelong aspirations – better home, a better car, vacations, etc.
3. After you retire, assuming the expenses will continue to grow at 8%, Rs.1.7Crs is good enough to sail you through roughly about 8 years of post-retirement life. 8th year onwards you will be in a very tight spot with literally no savings left to back you up.

What would you do after you run out of all the money in 8 years? How do you fund your life? Is there a way to ensure that you collect a larger sum at the end of 20 years?

Let’s consider another scenario where instead of keeping the cash idle, you choose to invest the cash in an investment option that grows at let’s say 12% per annum. For example – in the first year you retained Rs.240,000/- which when invested at 12% per annum for 20 years yields Rs.2,067,063/- at the end of 20th year.

With the decision to invest the surplus cash, your cash balance has increased significantly. The cash balance has grown to Rs.4.26Crs from Rs.1.7Crs. This is a staggering 2.4x times the regular amount. This translates to you being in a much better situation to deal with your post retirement life.
Now, going back to the initial question of why invest? There are a few compelling reasons for one to invest.

1. Fight Inflation – By investing one can deal better with the inevitable – growing cost of living – generally referred to as Inflation
2. Create Wealth – By investing, one can aim to have a better corpus by the end of the defined time period. In the above example, the time period was up to retirement, but it can be anything – children’s education, marriage, house purchase, retirement holidays, etc
3. To meet life’s financial aspiration

1.2 Where to invest?

Having figured out the reasons to invest, the next obvious question would be – Where would one invest, and what are the returns one could expect by investing.

When it comes to investing, one has to choose an asset class that suits the individual’s risk and return temperament.

An asset class is a category of investment with particular risk and return characteristics. The following are some of the popular asset classes.

1. Fixed income instruments
2. Equity
3. Real estate
4. Commodities (precious metals)

Fixed Income Instruments

These are investable instruments with minimal risk to the principle, and the return is paid as an interest to the investor based on the particular fixed-income instrument. The interest paid could be quarterly, semi-annual or annual intervals. At the end of the term of deposit, (also known as maturity period) the capital is returned to the investor.

Typical fixed income investment includes:

1. Fixed deposits offered by banks.
2. Bonds issued by the Government of India
3. Bonds issued by Government related agencies such as HUDCO, NHAI, etc
4. Bonds issued by corporate’s

As of June 2014, the typical return from a fixed income instrument varies between 8% and 11%.

Equity

Investment in Equities involves buying shares of publicly listed companies. The shares are traded on the Bombay Stock Exchange (BSE), and the National Stock Exchange (NSE).

When an investor invests in equity, unlike a fixed income instrument, there is no capital guarantee. However, as a trade-off, the returns from equity investment can be handsome. Indian Equities have generated returns close to 14% – 15?GR (compound annual growth rate) over the past 15 years.

Investing in some of the best and well run Indian companies has yielded over 20?GR in the long-term. Identifying such investment opportunities requires skill, hard work, and patience.

Taxation on Equity investments held for more than 365 days is taxed at 10%, if the gains are more than Rs 1 lakh starting from 1st April 2018(previously such investments were tax-free). This is comparatively a lower rate of tax than the other asset classes.

Real Estate

Real Estate Investment involves transacting (buying and selling) commercial and non-commercial land. Typical examples would include transacting in sites, apartments and commercial buildings. There are two income sources from real estate investments, namely – Rental income, and Capital appreciation of the investment amount.

The transaction procedure can be quite complex involving legal verification of documents. The cash outlay in real estate investment is usually quite large. There is no official metric to measure the returns generated by real estate. Hence it would be hard to comment on this.

Commodity – Bullion

Investments in gold and silver are considered one of the most popular investment avenues. Gold and silver over a long-term period have appreciated. Investments in these metals have yielded a CAGR return of approximately 8% over the last 20 years. There are several ways to invest in gold and silver. One can choose to invest in the form of jewellery or Exchange Traded Funds (ETF).

Going back to our initial example of investing the surplus cash it would be interesting to see how much one would have saved by the end of 20 years considering he can invest in any one – fixed income, equity or bullion.

1. By investing in fixed income at an average rate of 9% per annum, the corpus would have grown to Rs.3.3Crs.
2. Investing in equities at an average rate of 15% per annum, the corpus would have grown to Rs.5.4Crs.
3. Investing in bullion at an average rate of 8% per annum, the corpus would have grown to Rs.3.09Crs.

Clearly, equities tend to give you the best returns, especially when you have a multi-year investment perspective.

A note on investments
Investments optimally should have a strong mix of all asset classes. It is smart to diversify your investment among the various asset classes. The technique of allocating money across assets classes is termed as ‘Asset Allocation’.

For instance, a young professional may take a higher amount of risk given his age and years of investment available to him. Typically investors should allocate around 70% of their investable amount in Equity, 20% in Precious metals, and the rest in Fixed income investments.

Alongside the same rationale, a retired person could invest 80 per cent of his saving in fixed income, 10 per cent in equity markets and 10 per cent in precious metals. The ratio in which one allocates investments across asset classes depends on the investor’s risk appetite.

1.3 What are the things to know before investing

Investing is a great option, but before you venture into investments, it is good to be aware of the following…

1. Risk and Return go hand in hand. Higher the risk, higher the return. Lower the risk; lower is the return.
2. Investment in fixed income is a good option if you want to protect your principal amount. It is relatively less risky. However, you have the risk of losing money when you adjust the inflation return. Example – A fixed deposit which gives you 9% when the inflation is 10% means you are losing a net 1% per annum. Fixed-income investment is best suited for ultra risk-averse investors.
3. Investment in Equities is a great option. It is known to beat inflation over a long period of time. Historically equity investment has generated returns close to 14-15%. However, equity investments can be risky.
4. Real Estate investment requires a large outlay of cash and cannot be done with smaller amounts. Liquidity is another issue with real estate investment – you cannot buy or sell whenever you want. You always have to wait for the right time and the right buyer or seller to transact with you.
5. Gold and silver are relatively safer, but the historical return on such investment has not been very encouraging.

Key takeaways from this chapter

1. Invest in securing your future
2. The corpus you intend to build at the end of the defined period is sensitive to the return rate the investment generates. A small variation to rate can have a big impact on the corpus.
3. Choose an instrument that best suits your risk and return appetite.
4. Equity should be a part of your investment if you want to beat the inflation in the long run