Do not start Investing before you know this

People who learnt finances will want to make it seem difficult. Be it your friend who did MBA in finance or the stock expert who gives suggestions on TV every day. It is in their best interest that they discuss difficult finance. They want people like you and me to go to them. Best part in this field is you voluntarily choose to accept everything they say without give any thought to it just because you feel it is too complicated to understand. Basic finance that you need for your daily life is not difficult to understand. They come into play when you want to go beyond that. The stronger you are with few basic concepts, the harder it gets to fool you with wrong products. One of them that we discussed earlier is the money back guarantee plan.

Understanding finances or any investment structure is not a difficult task. It simply seems to be too complicated because it is too vast. Truth be told, we do not need all these information. We are not going to be an investment advisor at the countries best banks anyway. All we need to know is just those jargons or definitions and tools that we would need in our day to day life.

Inflation and Real Interest Rate

The rise in price of any good or service. Basically, if you could buy a new Innova at 15 Lakhs few years ago, today a new Innova costs you 25 Lakhs. If you paid 5 rupees for a samosa few years ago and you pay 10 rupees today, that’s inflation. In other words, if you have 100 rupees today and with that you can buy 10 oranges, the same 100 rupees next year can only buy you 9 oranges.

In India, we can assume an average inflation rate of about 6 - 7%. This also means that your investments should beat the inflation rate. This difference is the real interest rate you earn. Do not get exited when you see a product that gives you a fixed return of 6% every year. This means that if the inflation is 6% for the period you are invested, you in reality earn nothing. The purchasing power of your money does not change.

Now let me get you thinking. What is the savings account interest rate that you get on your savings account? 3-4%? Aren’t you losing money every year? Well, that is how the banks work.

Fun thought: If your employer gives you annual hike of less than the respective years inflation, you are in reality taking a pay cut.

Risk Tolerance

Every person has completely different risk taking abilities. As a thumb rule, we say the younger the age the higher the risks one can afford to take. But it need not be the same for you. You may be 30 but you may have several commitments to fulfil. You may be planning for your marriage next year and the funds that you need are to be protected. You may not have any other savings. Your appetite for risks can come down significantly until you manage your wedding expenses.

You may simply not have any big commitments but taking risks can give you sleepless nights. The whole idea of investment is to be at peace both today and tomorrow. If taking risks can bother you, you may choose to take lower risk. In all, you have to understand your level of taking risks. Once you understand that, you will be in much better position to choose your investment strategy.

If you go to any financial planner, the first question they probably would ask you is how much of the risk can you take. You will understand why understanding your risk-taking ability matters going forward. A lot of us undermine our risk averse nature to have a possibility of gaining higher returns. We tend to exaggerate our risk-taking abilities. This is even more evident when the market is growing every day. When the market falls, we tend to panic and exit the market as early as possible. That’s not how this works. Once you make a decision, you stick by it and neither worry about what’s happening outside nor what the “so called” experts say. There is nothing wrong is being a low risk taker. We are going through this whole process only to ensure that we live in peace. Best way to access your risk profile is to see how much of the risk you can take and sleep every night at peace.

Below are some of those questions that can help you in understanding your risk abilities. You are the best judge to decide how much of a risk can you take.

1. How stable is your income?

• Very stable

• Stable

• Unstable

2. How many people are dependent on you?

• No dependents

• 1 or 2 dependents

• 3 or more dependents

3. How much of your income is going into mandatory commitments (unavoidable) every month?

• < 10%

• 10 – 30%

• > 30%

4. What is your age?

• < 30 Years

• 30 – 40 Years

• 40+ Years

5. Do you have any short term goals (wedding, new house, etc.)?

• No

• Yes, but I am covered for those expenses

• Yes, I have to save upto the event

6. What is your investment horizon?

• 10+ Years

• 3 – 10 Years

• < 3 Years

7. You lost 30% due to market fall. What will you do with the stock?

• Buy more stocks

• Hold stock

• Sell and plan to buy when the market falls further

8. Where would you be comfortable to park your money?

• Equity or Mutual Funds

• Long Term Fixed Deposits

• Cash or equivalents

When you answer these questions depending on your current financial situation, you would be able to access your risk profile. If most of the answers for the above questionnaire were option (a), you can assume that you fall into a High-Risk Category. If your options where more on (b), you can safely assume that you are a moderate risk taker and low risk otherwise.

Liquidity

Liquidity in simple words is how easily you can convert your investment into cash. The most liquid asset is cash itself. Every asset has different degrees of liquidity. In the world of investments, equities (or stocks) are one of the most liquid assets. However, if there is no buyer to buy your stock, it can be an illiquid stock. The property you own may not be very liquid. It takes time and effort to sell your property at the market price. FDs are little less liquid than savings as you would need to break FDs and pay a penalty to do so to access the money.

Liquidity is quite necessary to understand as that should be one factor in your investment choice. There will be lock in for some products but if you need to access your money before maturity period, it would be difficult. Some assets might be very difficult to sell just because you have to find a potential buyer and convince them to buy the product.

CAGR (Compounded Annual Growth Rate)

You may be looking at your neighbourhood property and wondering about its price rise. You may have seen the property at 2.5 Lakhs per cents a few years ago when you wanted to buy a house but dropped it thinking it was expensive. The same property costs 8 Lakhs per cents today. Had you bought it that day, your asset would have grown multifold.

But let's look at this from a finance perspective. You may have looked at the property in 2005. The growth that you are wondering is over a period of 17 years. That amounts to 7% annual growth. In othr words, at a CAGR of 7%. The reason why you have to look at this metric is because you can easily get decieved by larger numbers. If the CAGR does not beat inflation in a handsome way, it does not make enough sense to get invested. In this case, you were better of keeping your money in an FD that paid 5-6% which would come with minimum risk compared to buying the property.