In terms of investments and returns, are you at the limit of gluttony?
It all started in the summer of 2004 when I started working with families on decisions about their finances. And the head of the first family I started working with was a chartered accountant and CFO in a large multinational (MNC) in Bombay. Our discussion, which lasted about forty-five minutes, was whether he had saved enough for his children’s education and retirement and whether he should buy another house or invest in Mutual fund.
This meeting got me thinking about why a successful man in such a high position needed the guidance of someone like me, who had just finished his MBA just a year ago. The answer (as some of you may have experienced in your life) is simple: we don’t spend enough time on our personal affairs as much as on the pressure of work and the lack of understanding of many options one could consider. I think there is another factor which, in my experience, is the most important. The advice available from various sources is generally not impartial, a situation similar to how we would not want our doctor to receive a share from the neighborhood pharmacist for each medicine prescribed.
Now, seventeen years later – with a big belly, more than a few gray hairs, and stints working in multiple areas of banking and running a business, I still think the basics of maintaining discipline in his financial life remain the same.
This column is not intended to provide financial advice. What I aim to do in this series is to put you on a path where you can make informed decisions about your financial life and evaluate different options in an easy to understand way.
As with any therapy, let’s start with a diagnosis. So, let’s start this journey and I hope you enjoy it!!!
Let’s take an example:
1. Kelly: I read in the newspaper that the shares of Moodle Ltd. increased by 20% in the last three months. Let me take out a personal loan and buy some stock.
2. Jimmy: I sold my ancestral land at a high price, now let me put that money into stocks that will surely give me at least 30% annual return.
Do Kelly and Jimmy look like you? If so, then the bad news is that you’re borderline greedy. However, just like borderline diabetes which can be managed with exercise and diet, the good news is that borderline greed can also be controlled by becoming aware of certain facts.
With high returns comes high risk: the returns from different types of investments are a compensation for the risks involved. This means that you should expect higher returns from riskier investments. But what does risk mean in investing? This means that the return is unpredictable, not fixed and its value can fluctuate, especially at a time when we need to recover our savings. Consider this: what can you say for sure: the stock market will rise 15% next year, or a bank fixed deposit (FD) will give you 7% next year?
It’s hard to predict that the stock market will go up that much and even if it does, it’s impossible for the markets to just go up. Some days it will increase and some days it will decrease.
Invest in stocks if you’re ready to see the stock market go up and down, can stay invested for 5-10 years (i.e. don’t depend on that money for immediate needs), and keep your expectations at annual returns of 10 to 12%. And the most sensible way to invest in stocks is through professional mutual funds.
Don’t fall for investment schemes/options that lure you in with the promise of higher returns.
On how much and when to invest: Start saving early in your working life and invest. Without complicating the decision, it is generally good practice to invest more in equity market-linked investments during young age and as retirement approaches, more and more savings should be invested in investments that give predictable returns such as FDs.
In general, what you are likely to spend (e.g. on a wedding or surgery) over the next year should be placed in investment options that do not fluctuate in value (e.g. bank FDs ).
By taking out a loan to invest: It’s a very bad idea to take out a loan to invest, unless you’re buying a house. For example, a personal loan from a bank costs no less than 14-16%. As we noted above, the best you can expect from an investment in stock market-linked mutual funds is 10-12% (anything more is good luck!). Why would someone borrow at 14-16% to get returns of 10-12%?
On inflation: as savers and investors, we also need to consider whether our investment returns are keeping pace with the rising prices of what we spend in general. Fixed-return instruments such as FDs fail miserably on this front.
Stay away from complexity: if a financial product is too complex to understand or the returns seem too good to be true, I would personally walk away. An example of such a financial product is the Unit Linked Insurance Plan (ULIP). Simply put, ULIP is an insurance plan that invests part of your paid premium in stock markets and also provides life cover, but much more complex to track than investing in a mutual fund and buying term insurance separately.
The facts discussed above will help you ask yourself the right questions the next time you have to make a decision related to money,
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