In this part of the greatlysimplifying investment series we will try to understand some of the basic aspects before investing. In case you are still wondering if you should invest please read the first part of the series here. Starting to invest is a very good decision, but it is also important to know some of the basic rules of the game. This decision has a bearing on your future and it is important to take out time to know about them. It is like knowing the depth and temperature of the pool before jumping in.
HOW DO I KNOW HOW MUCH I CAN INVEST?
This is a good start! It is important to be aware of your spending requirements on a monthly and yearly basis. Start with a simple excel sheet and capture all the expenses that you currently incur every month. Also include those expenses that you incur in other frequencies like annual insurance premium. Try to categorize these expenses as – Critical, Essential and Desired. Don’t worry, you’ll tend to feel more expense as essential when you do it first, but as you keep monitoring this, you’ll re-categorize some of them.
If you notice a surplus in this sheet, mark it as investment. At the first glance, you’ll be surprised to notice that there is actually no surplus left. If so, include an expense category called INVESTMENT in this sheet and forcible set aside a small amount. Start with any value that you are comfortable with in this category and re-adjust the rest of the expenses. If you are noticing a lot of money towards credit card bills, don’t worry at this moment, we will discuss that later.
Great! Now you know how much money you can invest. Don’t worry about the value, just remember the power of compounding! While investment evangelists recommend this famous 50-30-20 rule for personal finance, the first step is to know where you are and compare your current position against the recommended split. The idea is to progress towards the ideal level and aim to surpass!
OK, WHAT ABOUT SAFETY?
Am sure we have heard from our parents about that uncle who lost money in stock market and hence the need to be careful! This is an important consideration when it comes to safeguarding our investment. In financial terms this is called RISK. One of the safest ways to keep money is to put them in a box and bury it in your backyard. This strategy has worked in pre-historic era and some of our politicians continue to protect the heritage to this day! But in our current lifestyle even if we are able to accumulate the money we cannot find that elusive backyard. So this is out of the window!
While there are technical ways to calculate risk, the simple concept is what we need to understand. Imagine you are working in an organization earning a monthly salary. The probability of you getting your salary is quite high, unless you are working for one of the infamous airlines. Now is it the same probability when it comes to bonus? Now you are getting warmed up.
Imagine you join a company which agrees to pay you Rs 10,000/- as monthly salary. Instead as an alternative, they give you an offer that every month you toss a coin and if you get heads, you will get Rs 20,000/- or you roll a dice and if you get 6 you’ll get Rs 60,000/- or better still, if you draw Ace of spades you’ll get Rs 5 lacs! Now you are getting the drift right? So when you want to put away your money you’ll need some assurance about the certainty of the return and the capital. Now technically, in the above scenarios, the probability of your annual earnings is almost the same! Wondering how? Leave it at that!
This fundamentally, is risk. When you decide to invest, be clear of the risk in the investment scheme. It is important to know at this stage that risk and return are inversely related and hence you can earn more with riskier schemes. Don’t join the neighborhood Ponzi scheme yet!
In Simple terms the risk-return relationship looks like this:
In reality it looks like this, (called the efficient frontier)
BUT, CAN I USE THE MONEY WHEN I NEED?
When you decide your next trip to Spain what’s the use if you are not able to take the money that you have invested? This is the next criterion to consider while investing. This is called liquidity. The ability to surrender the investment and use the money when you need. The relationship between liquidity and returns are quite complex and it depends on various market dynamics. For eg., you may have invested in a government bond for a certain locked-in period which will give a lower return, however an apartment’s value could have grown tremendously in the same period. However, it is important to note that by the end of the tenure, the certainty that you get your return is very high in the bond than in the apartment. The ability to sell an apartment varies depending on various economic and market conditions. Just ensure that you don’t end up looking at the return without being able to use it!
IN A NUTSHELL
When it comes to investment, just remember the holy Trinity – Return (Brahma, the creator), Risk (Shiva, the destroyer) and Liquidity (Vishnu, the Preserver).
We will unravel more about how and where to invest in the next part in the greatlysimplified investment series.
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This is not an investment advisory. The intent is to simplify investment related concepts. Please seek professional advise before investing!
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