Definition of investment
Investment is defined as any use of resources intended to increase future production output or income. In the context of this article, investment is the use of our monetary resources to increase our income or profit.
Why is it important to know about investments?
Understanding about investments was always important, but never perhaps as important as it is today.
To begin with, there is a mismatch between our earnings and expenditure. By this, I mean that for those among us who are salaried, we earn a fixed salary per month, and this figure (hopefully) gradually keeps increasing. However, our expenditure pattern tends to be different. There is a fixed amount that we need to spend every month, which may include our day to day needs, rent / mortgage, car loan instalment, education for kids and so on. But, we would also have expenses coming on an irregular basis i.e. furniture, an occasion in the family, an expensive holiday etc. Further, we shall be working for a limited number of years, but quite likely, we will be living well beyond the retirement age. With longer lifespans and increasing health care costs in our old age, we need to plan our investments well in advance to prepare ourselves for the “golden years” ahead.
Your personality type and risk-taking ability
Before we explore areas of investing, we need to assess our own profile and risk tolerance levels. One’s risk tolerance level could differ depending on whether one is a young student starting out, a newly married couple, a middle aged working professional, a multi-millionaire businessman, a 65 year old widow etc. Our risk taking ability and willingness would vary depending on who we are and at what stage of our life and careers.
A young student starting out might have an entry level salary, limited expenses but maybe a loan to pay off. A newly married couple may have dual salaries but might be planning to buy a house and so would have to consider outflows on account of a future mortgage. A 70 year old widow would perhaps be focused on minimal risk-taking to ensure she doesn’t lose anything and makes enough return to take care of her daily expenses and some one-off health related spending.
As a general rule, I would always recommend taking a cautious approach to expenses based on our present income levels. This means that we should try and ensure that we keep our overall expenses well within our present income. For some of us, this tends to be more difficult than others, but in the long run, it’s an approach that almost always pays off. As we start saving more and more, we need to recognise that efficient use of this amount is going to ensure our sense of security and our lifestyle in the future.
Making an Investment Plan
With investments being so important for all of us, it is imperative that we spend sufficient time and effort to develop a good investment plan. Before developing an investment plan, we need to be aware of our income, our regular expenses, our irregular expenses (meaning expenses which come up once in a while) and an estimate of our future requirements.
In other words, you need to start out with taking an estimate of:
1. Present income
2. Your day to day expenses, mortgage, car loan, schooling of kids, insurance, health care etc.
3. Your one-off expenses. These can include your furniture, holidays, family occasions and events etc.
4. You finally need to make an estimate of how much you will save and how much of a nest egg you will need to build over a period of time to ensure sufficient availability as you close in on to your golden years.
Based on the above, you need to make an investment plan which should take care of:
1. Your short term needs- You need to set aside sufficient money to be able to take care of any short term requirements that you may have. These could be in the form of sudden medical emergencies, loss of job etc. Funds for these needs should be kept in liquid investments i.e. investments which can be withdrawn at short notice.
2. Your medium term needs – You may be single today, but you plan to get married in the coming few years and perhaps raise a family. You need to factor this into your investment plan considering the increased level of expenses that you might be faced with at that stage in the form of a larger house, a bigger car, schooling for child / children
3. Your long term needs – Over a longer time horizon, you need to build your nest egg to take care of your expenses post-retirement and to lead a decent lifestyle.
Types of investments
At a very broad level, we can classify investment types into:
1. Bonds: Bonds are usually securities that are in the form of debt. When one invests in a bond, one is effectively lending money to the government / company issuing the bond for a specific length of time and you will be compensated in the form of interest on a periodical basis and the original amount is paid back to you at the end of the period. The primary strongpoint of investing in a bond is the relative low level of risk. As long as you invest in a government issued bond, or a bond issued by a strong company, you will get back your interest and principal on time.
2. Stocks: Equities, or stocks, entitle you to own a small share in a business. When you invest in stocks of a company, you are a part-owner of that company i.e. a shareholder. You will be compensated from the profits of the company by way of dividends. Your primary income will come out of the dividends paid on your shares, and from capital appreciation in the value of the stocks. When you invest in stocks, you can participate in the growth of a company, and this can potentially mean a manifold rise in the value of your investments in a short period of time. However, the risk in such investments is high and you can very well lose a significant portion of your investments if the stock price falls sharply. This can be due to a sudden or gradual change in the prospects of the company which may hamper their future profitability.
3. Mutual Funds: When one buys a mutual fund, one is pooling his / her money with a number of similar investors and giving the job of buying securities (stocks or bonds) to a professional manager. Mutual Funds are set up with a specific focus, and this focus can vary significantly from one mutual fund to another. Some mutual funds would invest in bonds, which could either be government bonds or those issued by companies, some would invest in large cap stocks and others only in small cap, some might choose specific sectors e.g. automobile sector, infrastructure and others which might invest in specific markets i.e. emerging markets like China, Brazil, India etc.
4. Other investments: Other than the above broad types, there are a plethora of choices available for the investors, depending on his knowledge and understanding of the underlying assets, and his risk appetite. One can choose to invest in commodities (gold, copper, oil, agricultural products etc.), foreign exchange (investing in currencies other than your home currency), real estate (specific properties, Real Estate Investment Trusts, property derivatives etc.) and several other types. However, investing in any of these can entail significant risks for the investor. The other side of course is that one can stand to gain in a substantial manner also.
In my future articles, I will try and expand on the topics discussed above.
And I would love to hear feedback from you in the form of questions, comments and observations.
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