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Why Invest?

by Money Puzzle   ·  March 28, 2019   ·  

Why Invest?

by Money Puzzle   ·  March 28, 2019   ·  

1. Why what you save is not your investment

An investment gives you return. Of course, the first step is to save, but the act of saving by itself does not amount to making investments. Let’s assume you earn Rs 1000 every month and spend Rs 800 of it. That means Rs 200 remains in your bank account. Now comes the second month and the same thing happens; you earn Rs 1000, spend Rs 800 and have Rs 200 left in your bank account. Your bank savings at the end of month 2 have swelled to Rs 400 and if you keep this discipline up for the next 10 months, at the end of the year you would have Rs 2400 sitting pretty in your bank. Now, while you earn a default interest on this money, you can’t think that this is an investment.

To successfully invest your money, you must buy an asset. Assets grow in value and as they do that they give you a return. Property is an asset, so are equity shares, a business venture and some even consider gold as an asset. Now, if your bank manager sees that you are accumulating these savings in your account, she may recommend that you invest in a fixed deposit. A fixed deposit is a gainful way to keep your money secure but let’s not confuse it with an investment. You are simply lending your money to the bank and getting a fixed interest for it. The value of your money or investment is not growing.

While saving and securing your money may be the first step towards a disciplined money life, do not confuse it with making investments which help you create wealth and grow your money pile.

2. Why you need to invest

Now that you know what constitutes as an investment, you may ask, why its needed. Who cares if a fixed deposit is not an investment one can still earn anywhere between 6%-8% by lending money to banks and its safe so why bother with anything else? There isn’t just one reason, there are at least 3.

The first two reasons are simple. You pay both visible and invisible taxes on earnings; investing wisely helps you minimise the impact of these taxes. The income tax you pay is a visible tax. The interest (above Rs 10,000 a year) you earn on your bank account funds or your fixed deposit is subject to same rate of tax as you pay on your income. So, if you earn say 7% on your deposit or Rs 7 per Rs 100 at a tax rate of 10%, 70 paisa will go in paying tax. At a tax rate of 20%, Rs 1.40 will go in paying tax and at the highest tax rate of 30% Rs 2.1 will go in paying tax. I haven’t included all the cess that we pay. And then there are indirect taxes like GST you pay every time you buy something. Hence, what you earn is taxed. You need to invest so that your principle grows and you make a profit, interest income will not suffice.

The complete answer lies also in considering inflation. The reason that interest income does not suffice is thanks to an invisible tax called inflation.  

inflation takes away value from your money. In order to be able to buy the same basket of things you need more money every year and that means you must make your money work even harder than you are.

The last reason needs some foresight, but if you think about it. It’s the most important. So, here is the thing. You may feel that you have a fair amount of control over your income. You get a fair to good education, apply for jobs, negotiate salary and start earning. Two years on, you are frustrated by your job, you negotiate at the next offer – get a 25%-30% hike, feel happy and move on. However, most people’s earning capacity is also bound by decisions taken by the management or leadership at the helm and is not always a direct reflection of their own ability or skill. Its not just corporate leadership but also sovereign leadership which can control this. What better example than the recent American Government shutdown. It harmed several wage earners and their families. People struggled to repay loans and even put food on the table, because the jobs that they relied on to pay their salaries were shut down!

Read this (https://www.livemint.com/Money/iC8z4rl08CpNaNp4C5PF2O/Opinion–Decisions-by-top-few-can-change-fates-of-many.html) article I wrote to understand that this kind of event is not a one off and you are prone to all kinds of whimsical disturbances when it comes to your earning capacity. Yes, if you somehow make it to the 1% who lead, then you are undoubtedly better off, albeit you are still impacted by reasons 1 and 2. But that’s going to remain 1% of the people, most of us will not be part of that. Investing wisely helps you maintain your lifestyle and pay your bills when you aren’t earning as you did previously or expected to. It isn’t necessarily about retirement. It acts like an umbrella in a rainy day.

3. Why you need to start now

Investing sounds like serious business and perhaps it can wait till you have enjoyed life a bit. Being a grown up is stressful enough, surely there is no need to rush into this. Afterall, a 25 year old who has just started earning has at least 35-40 years of gainful employment to look forward to. While that is true, fact is the sooner you start investing, the more wealth you can create.

This happens because the value of an asset multiples over time. Unlike an interest paying instrument, which defines the pay out for say 1,3 or 5 years; a 6% per annum interest payment will remain the same throughout its tenure, asset values can grow multiple times. Equity as an asset class as shown to deliver 12%-15% per annum return if you remain invested over long periods like 10 years. That means your original capital grows at least 3 times. This concept is known as compounding.

But this exponential growth phenomena means that the sooner you start and don’t disturb a good quality investment, the bigger the return will be by the time you are ready to sell it. Rs 1000 invested in an asset, left undisturbed compounds to a value of Rs 3106 at the end of 10 years, Rs 9646 at the end of 20 years, Rs 29960 at the end of 30 years and Rs 93051 at the end of 40 years. So, if you want your money to grow nearly a 100 times by the time you retire in 40 years, you better start investing in growth assets now!

4. Why you should invest to create wealth

The answer to this question is embedded in the answer to question 2 above. In a word, inflation. inflation eats into the value of your money. At an inflation rate of 6%, the value of Rs 100 will fall to around Rs 56 at the end of 10 years. Hence, its important to invest in assets which will help you create wealth. Such assets are called growth assets.

growth assets through exponential returns over long periods of investment help you grow your wealth beyond the inflation pressure in the economy. By doing so you can grow your money pile and create wealth.

5. Why you need to have more than just one type of investment

Life is not always perfect and that applies to your investments as well. There are products with fixed return, which are likely to pay you that return at defined times. However, market linked investments like mutual funds, real estate or even your holdings in gold will fluctuate in value in the very short term and sometimes even over 1-3 year periods. In fact, your fixed deposit return too is known to vary in wide range of 6%-9% over periods of 5-6 years. Unfortunately, it is hard to tell in advance which asset class is likely to do well in which period. As result of this dynamic nature of asset returns, it is important to have some diversity or in a sense variety in your asset allocation. Data has shown that majority of Indian households have a disproportionate allocation to property. Nevertheless, having more than one type of asset helps to balance out the return you make over longer periods as on one asset class performs uniformly in each year.

For example, returns from your holding in gold is likely to shoot up if inflation is high but that could be a period of low return from equity as interest rates tend to be high too.

6. Why you need to be regular

First let’s understand what it means to be regular. Regular investors, put in smaller amounts of money but at pre-defined regular intervals. You may be doing it once a month, once a quarter or even once a week. The key is to be regular. Your doctor will tell you that having a regular eating schedule or regular exercise is good for health. Similarly, a regular sleep routine is good for health. Too much variation in any of these can result in illnesses in the short term and adverse diseases if carried on over longer term periods. In fact, irregular sleep habits are even known to be fatal.

We need to apply this basic logic in investments too. Be regular. Identify the investment period that suits you most and be sure to invest accordingly. For some investments like fixed deposits and provident fund, your frequency may be annual. But set aside a date or a month in which you revisit these investments each year. For your mutual fund investments, your frequency may be shorter like monthly or quarterly.

For those who own businesses or are entrepreneurs, it may be hard to make regular investments. Nevertheless, the endeavour remains the same. Your frequency, however, can be defined with each cash inflow. Keep aside a fixed proportion for the purpose of investment each time you get a cash inflow.

Being regular helps create investment discipline, which is a key aspect of accumulating long term wealth.

7. Why you should invest first and spend later

This is a simple answer. It is easier and more tempting to spend. Envisaging or forecasting future need for wealth is very hard for anyone to do. Yes, you can put down numbers on an excel sheet, but even that is hard to do and not everyone is going to do it. There are several popular and successful entertainment and sports personalities across the globe who mismanaged their finances and landed up declaring bankruptcy. Michael Jackson was hugely in debt at the time of his death, the reason was over spending.

Buying too many things is going to give you some momentary pleasure, but will rarely ever result in any real satisfaction. More important is too focus on being able to maintain a reasonable lifestyle throughout your life. You may not be able to calculate the exact amount required to save or invest for your retirement 20-30 years away, but you should know that you have to save and invest for your retirement.

Start with smaller amounts, but invest at the start of the month and forget about it. Spend whatever you have left.

8. Why saving tax is not investing

When you are deciding your investment products, the assets and so on, let tax saving not be your first criteria. The way the Indian tax system works is that you get some amount of tax exemption if you invest in certain notified investment instruments. While this will be beneficial if you are eligible, this should not be your only guide for investing. Investing is always a long-term phenomenon, which, if you have read the answers above, needs to incorporate a logical asset allocation. The end objective of your investment should cater to things like retirement or other scared spends that you may have earmarked throughout your life journey. Saving tax can perhaps shore up your annual income by a factor of say 0.1%-5%, but will not have a meaningful impact when your compare with choosing the right asset to maximise long term returns.

9. Why you need to think long term

I keep using the phrase long term, because for most of us wealth creation through investments will not happen in a period of 1,2 or 3 years. Now there are others who are well versed with financial assets like stocks and bonds and are able to make large sum investments in trades which last all of a few months. At the end of which, they have made 3-4 times return on capital. We may all wish to be able to do this, but its unreasonable to think that someone who is not involved in that line of work ie trading will be able to do that with any degree of consistent success.

The option then is to focus on a disciplined approach and give your growth assets time to ripen. Now, in case of equity investments a period of 7-10 years is historically seen as long enough to generate positive, inflation plus returns with a high probability of success. In case of Real estate too market cycles can last up to 10 years. Hence, if you are investing in property for the purpose of return and not to reside, then expect to hold it for at least 10-12 years post completion. It could be a lower period depending on the phase of the cycle and for land investments it could be a longer period too.

The long term nature of wealth creation also means that you have to start as early as possible. The sooner you start the sooner you will be able to create a larger corpus. Remember compounding? This matters because, for those who are not compulsive workaholics, having a large corpus of wealth can free up time to focus on other meaningful pursuits in life.

10. Why you should invest with a nominee

All your understanding and actions around investments are worthless, if these don’t benefit your family. As you get older, get married, have children and so on you will realise the importance of prudent investing. However, life is unpredictable and if something were to happen to you or your spouse, your children’s future can be made uncertain too.

For a smooth transition of assets to those who are dependent on you and your earning capability, it is important to assign nominees for each of your investments. If the process of assigning nominees is not straightforward, write a will and get it registered.

This will resolve any time-consuming process when it comes to claiming investments by your dependents in your absence. You could nominate your spouse or your children or even your parents in some cases.

If investments are inaccessible to your loved ones when it matters the most, then the purpose of wealth creation itself is lost.

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