One of the key ingredients to create wealth over time is to have an investment plan in place and a strategy to implement it. An ideal way to make an investment plan is by considering certain key factors like current financial situation, investment objectives, attitude towards risk and the time horizon.
Understand the risk-reward connection
It would help to know that risk is an inherent part of investing and that there is a direct co-relation between risk and reward. The level and the type of risk one takes depends on one's time horizon i.e. the length of time one has to achieve one's investment objectives. For a short-term investor, volatility is a bigger risk than inflation.
Therefore, a short-term investment strategy should focus on capital protection through a portfolio consisting of interest-bearing securities.
Conversely, for a long-term investor, the annualised rate of return is key. That's because volatility tends to work itself out with the good years offsetting the bad years. Besides, for a long-term investor, compounding plays an important role, as it helps in making money on the money already earned.
Spread your eggs
All of us have our own definition of risk and most of us equate risk with the potential to lose a part of the capital. However, there are risks such as inflation that don't allow money to grow in real terms.
For a long-term investor, it is crucial to earn positive real rate of returns i.e. returns minus inflation to take care of escalating costs.
The real issue, therefore, is to find and maintain your balancing point that can ensure success at a risk level you are comfortable with. This is where an asset allocation strategy has a role to play. An asset allocation strategy aims at spreading the money across different asset classes such as equity, debt, real estate and commodities, thereby reducing portfolio risk.
As we all know, different asset classes perform differently in different market conditions. For example, the stock market does well during an economic boom, and loses ground during recessionary times. The bond market, however, behaves in the opposite manner—it does well in recessionary conditions, and not so well in a booming economy.
Remember, creating wealth is a process that requires discipline and commitment to invest on a regular basis. Therefore, you shouldn't allow short-term turmoil in the markets to block your vision for a better financial future.
The right way to proceed is to look around for appropriate and tax-efficient options rather than invest in a state of fear and miss out on opportunities to make the money grow at a healthy rate.
Thankfully, there are various investment options to suit the needs of investors with different risk appetite and temperament. Let us analyse a few of these and see what role they can play in the process to create wealth:
Equity as an asset class is potentially better than other options. But if you invest in equity, your probability of facing higher volatility in the short-to-medium term goes up too. You can tackle this risk by investing on a regular basis.
Investing in equities is an on-going process and not a one-time activity. If you do not have a lump sum and would still like to invest in equities, investing through a Systematic Investment Plan [SIP] in an equity fund is perhaps the best way for you to create wealth.
It is important to consider the level of exposure to equities vis-a-vis the overall portfolio size. Remember, it is this level of exposure to equities that decides the likely impact on the overall returns and the level of risk.
Another issue that needs to be addressed is whether one should invest directly in the stock market or choose a diversified investment vehicle like a mutual fund [MF]. Many investors find investing directly into the stock market more exciting as they get to hear about a lot of success stories.
However, direct investment can be quite risky, if the stock selection and the investment process followed is faulty—like if you rely on tips and invest aggressively to make a quick buck.
If you are a serious and genuine investor, you are likely to do better by focusing on overall growth of your portfolio rather than looking for excitement.
MFs can be a better option as they are not only diversified in nature, but also offer many other benefits such as professional fund management, high-level of liquidity through open-ended funds, transparency, flexibility, variety of options and tax efficiency.
While investing in MFs, it is always advisable to focus on diversified equity funds. Though some of the aggressive funds, like sector and thematic funds, can be tempting, one should avoid investing in them at least in the initial phase of portfolio building.
Remember, there will always be bull and bear markets and it will always be nearly impossible to predict the movements of the stock market. The best one can do is to take an informed decision and adopt a sensible approach by investing for the long term.
Debt and debt-related options
For conservative investors, the traditional investment options like bank deposits, bonds, small savings schemes and debentures have been the mainstay of their portfolios for years. Although these instruments do address their concern for the safety of their hard-earned money, most of these do not play a role in the wealth creation process.
That's because they not only offer low returns but also are not tax-efficient, barring PPF [Public Provident Fund]. Besides, lack of liquidity in most of these instruments can be a major hindrance in the flexibility required to make changes in the portfolio from time to time.
The time has come to look beyond these for at least a part of the portfolio and explore options like debt and debt-related funds offered by MFs. These are not only tax-efficient and flexible, but also have the potential to provide better returns.
MFs offer various types of funds in this category to suit the requirements of investors with different time horizons and risk profiles.
These are ultra short-term income funds, short-term income funds, income funds, gilt funds, Fixed Maturity Plans [FMPs] and other debt-oriented hybrid products such as Monthly Income Plans. Investing in the right options can go a long way in improving returns without getting exposed to higher risk.
Notwithstanding the recent volatility in the prices, gold continues to remain one of the effective investment options. Considering that it would take some more time for the global economies to recover fully from the setbacks of 2008, an alternative asset like gold will remain an attractive investment option.
However, as the gold prices are likely to be volatile going forward, you would be better off buying periodically rather than investing a lump sum.
Remember, the ultimate role that gold plays in a portfolio is that of hedging against the inflation. Therefore, one needs to restrict the exposure to gold to around 10 – 15 per cent of the portfolio.
In today's times, the better way to invest in gold is through Gold Exchange Traded funds [GETF], rather than buying physical gold, which has many risks and logistic issues. GETFs allow investment in gold in small denominations thereby allowing retail investors to participate. In a GETF, one unit represents one gram of gold. These can be bought on a stock exchange through a stock broker.
Insure your wealth
As is evident, the process to create wealth requires an investor to not only adopt a disciplined approach, but also choose the right options and in the right proportion. More importantly, our dreams for our near and dear ones are attached to the wealth that we create over our life time.
Therefore, it is absolutely crucial to ensure that in case of any eventuality, the lifestyle of family members is not compromised. To ensure this in today's uncertain world, it is essential to have sufficient life insurance cover.
Of course, the quantum of insurance cover would depend upon one's personal situation. It is equally important to opt for a suitable insurance product. For example, term policies are the cheapest and the most effective ones among all the insurance products.
Then there are products like Unit Linked Insurance Plans [ULIP], which can be suitable for someone who is looking for a product that can take care of his multiple needs and has a time horizon of at least 10 – 15 years. Ideally, it pays to keep insurance and investment separate as the objectives and expectations are different from each of these.
Last but not the least, take the help of a professional advisor to guide you through the maze of investment world. However, it is equally important to know that you, yourself, have an important role to play in the decision-making process.
No one will know about your objectives, needs and risk profile better than you. While an advisor can help you in terms of determining the course of action and selection of investment options, you have a big role to play in defining the parameters.
Spot an error in this article? A typo maybe? Or an incorrect source? Let us know!