Before we address the above question, let us understand what would happen if one chooses not to invest. Let us assume you earn Rs.50,000/- per month, and you spend Rs.30,000/-towards your cost of living, which includes housing, food, transport, shopping, medical, etc. The balance of Rs.20,000/- is your monthly surplus. For the sake of simplicity, let us ignore the effect of personal income tax in this discussion.
To drive the point across, let us make a few simple assumptions.
Going by these assumptions, here is how the cash balance will look like in 20 years.
If one were to analyze these numbers, one would soon realize this is a scary situation to be in.
Few things are quite startling from the above calculations:
What would you do after you run out of all the money in 8 years? How do you fund your life? Is there a way to ensure that you collect a larger sum at the end of 20 years?
Let’s consider another scenario where instead of keeping the cash idle, you choose to invest the cash in an investment option that grows at let’s say 12% per annum. For example – in the first year you retained Rs.240,000/- which when invested at 12% per annum for 20 years yields Rs.2,067,063/- at the end of the 20th year.
With the decision to invest surplus cash, your cash balance has increased significantly. The cash balance has grown to Rs.4.26Crs from Rs.1.7Crs. This is a staggering 2.4x time the regular amount. This translates to you being in a much better situation to deal with your post-retirement life.
Now, going back to the initial question of why invest? There are a few compelling reasons for one to invest.
Having figured out the reasons to invest, the next obvious question would be – Where would one invest, and what are the returns one could expect by investing.
When it comes to investing, one has to choose an asset class that suits the individual’s risk and return temperament.
An asset class is a category of investment with particular risk and return characteristics. The following are some of the popular asset classes.
These are investable instruments with minimal risk to the principle, and the return is paid as an interest to the investor based on the particular fixed-income instrument. The interest paid could be quarterly, semi-annual or annual intervals. At the end of the term of deposit, (also known as the maturity period) the capital is returned to the investor.
Typical fixed income investment includes:
As of June 2014, the typical return from a fixed income instrument varies between 8% and 11%.
Investment in Equities involves buying shares of publicly listed companies. The shares are traded on the Bombay Stock Exchange (BSE), and the National Stock Exchange (NSE).
When an investor invests in equity, unlike a fixed income instrument, there is no capital guarantee. However, as a trade-off, the returns from equity investment can be handsome. Indian Equities have generated returns close to 14% – 15% CAGR (compound annual growth rate) over the past 15 years.
Investing in some of the best and well run Indian companies has yielded over 20% CAGR in the long term. Identifying such investment opportunities requires skill, hard work, and patience.
Taxation on Equity investments held for more than 365 days is taxed at 10%, if the gains are more than Rs 1 lakh starting from 1st April 2018(previously such investments were tax-free). This is comparatively a lower rate of tax than the other asset classes.
Real Estate Investment involves transacting (buying and selling) commercial and non-commercial land. Typical examples would include transacting in sites, apartments and commercial buildings. There are two income sources from real estate investments, namely – Rental income, and Capital appreciation of the investment amount.
The transaction procedure can be quite complex involving legal verification of documents. The cash outlay in real estate investment is usually quite large. There is no official metric to measure the returns generated by real estate. Hence it would be hard to comment on this.
Investments in gold and silver are considered one of the most popular investment avenues. Gold and silver over a long-term period have appreciated. Investments in these metals have yielded a CAGR return of approximately 8% over the last 20 years. There are several ways to invest in gold and silver. One can choose to invest in the form of jewellery or Exchange Traded Funds (ETF).
Going back to our initial example of investing the surplus cash it would be interesting to see how much one would have saved by the end of 20 years considering he can invest in any one – fixed income, equity or bullion.
Clearly, equities tend to give you the best returns, especially when you have a multi-year investment perspective.
A note on investments
Investments optimally should have a strong mix of all asset classes. It is smart to diversify your investment among the various asset classes. The technique of allocating money across assets classes is termed as ‘Asset Allocation.
For instance, a young professional may take a higher amount of risk given his age and years of investment available to him. Typically investors should allocate around 70% of their investable amount in Equity, 20% in Precious metals, and the rest in Fixed income investments.
Alongside the same rationale, a retired person could invest 80 per cent of his saving in fixed income, 10 per cent in equity markets and 10 per cent in precious metals. The ratio in which one allocates investments across asset classes depends on the investor’s risk appetite.
Investing is a great option, but before you venture into investments, it is good to be aware of the following…