In this article, I
will cover some basic concepts including inflation, compounding, savings,
investments, financial planning, various investment avenues etc.
Why save money?
Most of us are
earning good amount of money and many think why not spend it all and have fun?
Why bother saving any of it as we are confident that we can keep earning in the
foreseeable future? Short answer is to be financially secure. For life.
There are needs that
require far more amount of money than our monthly salary. You need to pay 2-3
lakhs now a days to get your kid admitted into a good school and there are so
many such requirements. True there are banks eager to offer loan for everything
but they would expect you to pay back large interest and EMI would drastically
reduce amount available to fulfill rest of your needs.
What do you do if an
accident puts you on bed for few months or a recession makes you loose your job
and you fail to find another one for a few months? Would you have more peace of
mind when you have enough savings to sustain for a few months or when you have
nothing?
Everybody is going
to become too tired of job some day and would retire. How would he survive if
he has no savings? We Indians count on kids too help us out post retirement. I
would be lucky if my kid earns enough and is willing to help me out. So am I going
to count on my luck? No. I would rather plan, save and invest.
So it's very
important that we must save a large amount on money during your productive
years so that it would support us during bad time or post retirement. I would
encourage you to read following articles:
We keep hearing
about high inflation, CPI, WPI and all that jazz every now and then, but should
we really care? Yes because inflation is far more than just a concept as it
depicts that purchasing power of money decreasing over time.
As I remember during
my childhood, monthly groceries used to cost hardly Rs 1000/- for the family of
4. However now just for the family of 2, even Rs 2000/- not enough just for
weekly grocery. The 1 BHK that I rented in 2006 when I came to Bangalore for Rs
5000/- now costs Rs 10000/-. That is 100% growth in just 7 years which is
roughly 10% inflation annually. Prices
of groceries, fuel, medicines etc have increased too.
That humble Rs 100/-
note used to be far more valuable for my father when he was young. You would
call me foolish if I tell you to put Rs
10000/- in a piggy bank for retirement
because after 30 years, it would hardly be equivalent to about Rs 800/-
assuming 8% inflation.
Hence for financial
security, just savings are not enough. You need to ensure that you invest it
wisely and get more returns than inflation. Inflation has been in double digits
in last a few years and it would be safe to assume long term inflation of about
8-9%. Hence if your FD interest is 9%, or ~6.3% after accounting for income tax
assuming highest tax bracket, the reality is that value of your savings is
decreasing with time.
Hopefully we now
agree that we need to save & invest. The next questions comes into mind is
when is the right time to start? Most of us still have too many years to retire
so why bother now?
Let's take an
example. My friend 'A' starts investing Rs 5000/- every month in a good MF
through SIP soon after joining his job when he was 22 years old. He wants to
retire at 60 and guess how much he would
have assuming 12% return? Rs 3.66 crore
for the investments of about Rs 23 Lakh.
What if he decides
to start when he is 40 years old and invests Rs 25000/- every month? Rs 2.16 crore for investment of about Rs 60
Lakh.
What if he starts
when he is 50 and invests Rs 100000/- every month? Rs 2.1 crore for investment of about Rs 1.2 crore.
So what is going on
here? How come humble Rs 5000/- investment per month over 38 years beats Rs 1
Lakh per month by more than 70%? Let's see what happens in the first scenario.
After starting at 22 with Rs 5000/-, when 'A' turns 40 years old, he has already
accumulated about Rs 33 Lakh. Hence though this year he invests only Rs 60000,
the interest that he gets is whopping Rs 4 Lakh. When he turns 50, his
accumulated wealth is Rs 1.1 crore on which he earns interest of Rs 13.2 lakh.
That's the magic of compounding my friends.
The simple message
is start saving & investing and start as early as possible. Time is running
out fast.
Is saving certain
amount every month enough? No. That's certainly most important part of
financial planning but there is more:
- Life insurance: when you have dependents , it's critical that you have some term insurance with enough sum assured in case something happens to you.
- Health insurance: health insurance too is equally critical as some sudden medical emergency might cripple your finances. Health insurance is actually wealth insurance.
- Emergency funds: you must keep enough money to sustain for 3-6 months in non-risky avenue like savings account, FD or debt fund for some unforeseen emergency situation like job loss
- Planning for goals: you must have a plan in place for goals like retirement, kids education, buying a house etc
- Estate planning: having a will is really important to ensure that your heirs are not left in legal tangle if something unfortunate happens to you
More on financial
planning soon.
Debt versus Equity
Most of us are
generally familiar with debt investment options that include bank accounts,
FDs, RDs etc. where rate of interest is fixed and guaranteed. These options are
less risky but return too is low.
Equity mean
ownership. When you buy shares of some company, you become owner of it and you
get proportionate claim on assets and profits. Your investment does well only
if company does well and stock market acknowledges it. There is basically no
guarantee regarding interest or return. In equity risk is far higher but so are
returns.
I can't stop
stressing on the importance of equity and equity investments are critical to
beat inflation in the longer term.
What are the
different options available for saving & investing money:
- Bank accounts, FD, RD, NSC, Post office deposits: saving account is good options for keeping money for day to day expenses or emergency funds. However you get hardly 4% interest per year. FD/RD/NSC returns are slightly more but after accounting for tax, they general don't beat inflation.
- PF, PPF, Tax free bonds: These are promising instruments for long term requirements like retirement planning. Returns are tax free and they generally beat inflation. You can get some tax breaks too.
- Traditional insurance policies and ULIPs: As I mentioned in my previous articles, these are bad investments and must be avoided at all costs. More on these in my previous article
- Real estate: is very popular choices among Indians. Home is basic requirement and generally own house is better than rented one. People however choose to speculate and in the hope for getting rich quick, they end up investing in multiple of them without realizing that not many of them give multibagger returns . Many people prefer to invest in land/plot and commercial properties like office or shops. Real estate is generally good investment avenue but it's highly risky, comparatively illiquid and requires a lot of care to get it right.
- Gold: is another very popular choice among Indians. Few years back it gave better returns than equity but this year it didn't perform as good. People believe it's value will always increase in long term but some also say it's a bubble. Gold is again a high risk investment and as per most experts, one should not investment more than 10% of his investments in gold.
- Shares & trading: These are a very risky and bad options for general public. I see that most people just speculate in share market and do rackless & mindless trading. They seem to make some money during good time but are crushed during bad times. These could be as harmful as buying lotteries and may people end up loosing a lot of money (I am telling this with first hand experience :P). So in short these are very risky with high returns and requires very specialized skills. Hence they should be avoided by most people.
- Equity Mutual funds: Mutual funds manage pool of money from multiple people by investing it in shares by dedicated professionals. They are called fund managers and many of them have specialized degree and number of years of experience in share market. It's much easy to invest in these and they are low cost and tax efficient (no tax on if invested for more than one year).. These are risky with high returns & are critical to beat inflation. Recommended way is to invest regularly in them through monthly systematic investment plans (SIPs). More details on MFs in my previous article
- Debt mutual funds: Debt mutual funds invest in corporate deposits which are risker than bank FDs. But again these are managed by professionals hence these are less riskier than corporate deposits. These are also low risk and low (and not guaranteed) return instruments and they hardly beat inflation. These are more tax efficient than FDs (income tax rate applicable is only 10% or 20% with indexation if held for more than one year v/s 30% in case of FDs assuming highest tax bracket). These are good for emergency funds and other similar debt/safe investment requirements.
I hope this article
provides a good overview of financial landscape. Please let me know your
thoughts, feedback and comments. Also if you liked it, please do share it on
facebook/twitter/linked-in and email it to your friends & mail groups.
Further reading:
- The Equity Imperative: by not investing in equities for the long term, too many Indians are setting themselves up for old age poverty
- Time is Everything: the only reliable way of growing your savings at a rate faster than that of inflation is to invest it into equity or equity based investments
Disclaimers and disclosures:
The views shared
here are based on my own knowledge and research. Whatever advise I am offering
here is best based on my own knowledge & abilities. I would like to
reiterate that equity investments are risky and there are no guarantees.
However avoiding equity completely is riskier. The risk associated with them
can be managed and that's what I am trying to put it across in simplest
possible terms. More on this here.
I am not going to
get any commissions from any mutual fund etc in case you act on my advice and I
don't take any legal responsibility for any losses that you might incur (at the
same time not asking you to share your gains with me :P).
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