October 28th, 2013
John, living in an emerging country (with double digit inflation) is a 26 year old software engineer earning a salary of USD 10,000 per month. He started his career pretty early in life and is still unmarried. Now he is planning to settle down and start his family within a period of 4 years.
He estimates his monthly expenditure to be about USD 2,000 and is paying a monthly rent of USD 1,000. He is also paying an EMI of USD 700 on his Volkswagon Beetle that he bought last year!. His immediate needs are limited, but he wants to have some ready cash at the time of his marriage.
John is thinking about an annual savings of about USD 60,000 (after paying income tax etc.) in a bank in the form of fixed deposits and then utilize the amount as per his requirement required. But is it the right strategy?
What would be your advice??
The Rule of 70!
With inflation in near double-digit figures and prices rising unchecked, whatever he is getting now for USD 100, will be costing nearly double (USD 200) in five years time
- Remember rule of 70 i.e. in order to estimate the number of years for the prices to double
- Take the number 70 and divide it by the inflation rate - The post-tax return, one will get from bank will be nearly 7%
John has to adopt some means to beat the inflation and get the required growth in his wealth to meet his targets. This is best done by asset allocation.
Asset allocation helps you determine how you invest your money in different investment classes in a proper mix. The first is to establish what type of portfolio he wants to build (decide on the right asset allocation). Besides the stocks and bonds, there are different kinds of asset classes like Mutual funds, Hedge funds, real estate, commodities etc. to consider.
Remember, the type or class of security you own i.e. equity, debt, or money market, is much more important than the particular security itself. Determine what your financial goals are.
- Are you investing for retirement? A child's education? Or for current income?
- Consider your time frame. Do you need money in three months time or three years? The longer your time horizon, the more risk you may be able to take.
- How do you feel about risk? Are you in a position to tolerate the ups and downs of the stock market for the possibility of higher returns? It is necessary to know your own risk tolerance. It can be a guide for choosing the right schemes.
Remember, regardless of the potential returns, if you are not comfortable with a particular asset class, you should consider other options.
Investing is a complex exercise only because we insist on making it so. Investment in the real estate at John's age can fulfill long term goal. He has to meet his immediate aspirations of beating the inflation. But the basic principles are simple. Historically, equities have proven to be the best performing long-term asset class.
One must follow the steps listed below for proper investment strategy
Develop a Plan
The popular thumb rule for asset allocation - whatever the investorâ€™s age, he should keep that percentage of his portfolio in debt instruments. For example, if an investor is 26, he should have 26% of his investments in debt instruments and the rest in equity. However, in reality, different circumstances like age, occupation, number of dependents in the family and financial position for each individual may require different allocation. . Usually the younger you are, the riskier the investments you can hold for getting superior returns.
For short-term goals, make sure you're taking appropriate risks. Invest money that you'll need in the next two years to five years in cash and short-term bonds.
If you've taken on too much risk for short-term objectives, pull back now. nobody knows the bottom the market. It's better to cut your losses and preserve the money you already have for short-term goals. For your long-term financial goals, consider equities.
Golden Roles for Investing!Keep It Simple:
If you decide to invest in mutual funds, buy a diversified equity fund or an index fund for equity exposure and a floating-rate bond fund for fixed income exposure. These are the basics of the investment world. To keep fund selection simple, stick with a diversified equity funds of well-established fund families. Ignore the hot stocks and funds: If you buy this year's top-performing fund or stock, be prepared to see it at the bottom next year. The fancy academic expression for this phenomenon is -- Reversion to the Mean. But the old saying explains it just as well -- what goes up must come down.Invest Regularly:
Investing a little bit of money each month is the surest way to reduce the risk of investing, because you lessen the possibility of buying at the market top. Also, no one is smart enough to anticipate all the moves, both up and down.Buy and Hold:
Short-term trading makes more brokers than investors rich. No long term investor has made any money in trading. Set your goal and sell when you require or when it has reached your target.Start Early:
It is not the "market timing" but time in the market that matters. Power of compounding will turn things in your favor. Investing is a long-term proposition. Research your investments, remember your goals, re-examine your risk, and make the asset allocation prudently. And don't let your emotions overpower your sense of reason.
CFA Program is the gold standard in education and lays a strong foundation on asset allocation and understanding the principles of investment. If you are interested in gaining a fundamental stronghold on your finances, you can consider enrolling for the CFA examination. More details about the examination can be obtained by sending an email to firstname.lastname@example.org or calling +91 989 298 0608
About the Author
An MBA from IIM Indore and a B.Tech. and M.Tech from IIT Delhi in Mathematics and Computing, Paramdeep is a director with Pristine. Prior to founding Pristine, he was working with Standard Chartered Investment Banking as a Senior Manager.
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