Tuesday, August 23, 2011

Understanding Investment Risks

For a common man, the term 'risk' simply means 'uncertainty' often for an unfavourable result. But for a person from finance, the term risk assumes a special meaning, referring to the “variability in expected returns'. In simpler words, in indicates the chance that an investment's actual return will be different than the expected return.
In this article, we will introduce you to the different types of risks involved in the world of investments. This knowledge would help you to better understand the different risks you are exposed to whenever you are making any investments. To begin with let us classify investment risks into two types depending upon whether we have any control in managing them. Investment Risks are broadly classified into (i) Systematic risks and (ii) Unsystematic Risks.
Systematic risk: Systematic risk relates to factors that affect the overall economy or the securities market and hence is also known as 'market risk'. It is something which is beyond the control of an investor and cannot be avoided. The common systematic risks affecting investments are:
  1. Interest-Rate Risk: This type of risk describes the risk that the value of security will go down with the changes in the interest rates. This risk directly affects debt products like Government bonds, Certificates of Deposits, Treasury Bills, etc. For example, when interest rates increase, the old bond prices fall since the investors will now prefer the newer bonds offering higher interest rate. Also, in the case of falling interest rates, the bonds that are maturing or paid off before maturity have to be re-invested at the lower interest rates in the market. The risk is higher for securities of higher duration / maturity period.
  2. Inflation Risk: The increase in the price of goods and services, in other words, the cost of living reduces the purchasing power capability. This is termed as the inflation risk. This is something we all are experiencing in India where the value of money has decreased and the returns or interest incomes are insufficient to counter the rise in price levels, and also the value of investments have eroded.
  3. Currency Risk: It is a form of financial risk that arises due to the change in the exchange rate of one country in relation to another. Cross border investors or businesses are impacted due to currency risk if they transact in a foreign currency, invest in international funds or borrow/lend in a foreign currency.
  4. Liquidity Risk: Liquidity risk arises if one is unable to buy or sell funds quickly enough to minimize or mitigate losses. Sometimes one may not be able to sell an investment if there are no buyers for it or even if the credit rating for the institution falls. Liquidity risk is generally the highest in case of shares of small companies.
  5. Socio-political Risk: This type of risk is caused due to the possibility of an unrest or war in a particular region that may affect the investment markets. For example, the attack on the WTC and Pentagon in September 2001 had caused a wide scale disruption of the financial system. Similar kind of events may pose great danger. Similarly, if one is investing in another market, the change of government can also cause socio-political risk if that government brings about unfavourable changes in the system.
  6. Regulatory Risks: Risk arising due to change in regulations which adversely impact businesses. It also includes Tax Risks which directly impact the revenues of the companies.
  7. Volatility Risk: It is the day-to-day fluctuations in the prices of stocks and bonds.
Unsystematic Risk : Un-systematic risk is the risk limited only to a small number of companies or specific industries or securities and is uncorrelated to the markets. The risk is inherent in the nature of such securities and thus it is also known as 'specific risk' or 'diversifiable risk' since the investor can avoid such risks by limiting his/her exposure to such investments. Diversification is a good way to mitigate this risk since if you are investing into different asset classes and different securities, specific risks associated with each of them has little impact on your overall portfolio. The common Unsystematic risks are:
  1. Management Risk: A wrong decision taken by the company management, internal disputes or even some external situations can cause management risk, also known as company risk. Such steps affects the performance of the company and that in turn, would affect the value of an investor's holdings in that company. It is a case when the management puts his personal interests before the company interest. For example, in the case of Satyam, it was a well respected company till the management revealed about the financial mess it was in. The investors lost crores as a result of this news.  
  2. Credit Risk: Credit risk, also known as default risk, is a situation when the bond's issuer's likely failure in paying the interest as scheduled or failure in paying the principal amount upon maturity. Credit risks are calculated based on the borrower's overall ability to repay the due amount on time. The higher the credit risk, the higher the interest rates that will be demanded by the investors for lending their capital.
  3. Business Risk: It is the uncertainty of risks associated with the company's operating environment which impacts the ability of the company to have adequate cash flow to meet its operating expenses. A business risk may arise due to a circumstance or factor that may have a negative impact on the operation or profitability of a given company.
Behavioural Risks:
Apart from the investment risks arising out of the securities, there are also many risks arising out of the behaviour or actions or inactions of the investor himself. Such risks arise often due to involvement of emotions in investing, especially the emotions of 'fear', 'greed' and 'hope'. Further, risks may also arise due to lack of investment expertise or knowledge, especially when you are investing in high risk products like direct equities or derivatives. Significant investment risks also arise by not regularly reviewing your portfolio or by following an asset allocation unsuited to your profile. The behavioural risks are in fact more crucial to understand in investing, the benefits of which can help us make much smarter decisions.

Risk is universal:
As investors we need to understand that there is nothing truly risk-free in this world. Risk is omni-present in every choice, action we take in life and in every place at all times. Talking of investments, what really matters is the trade-off between risk & return. A smart investor is one which understands this trade-off and uses it to his advantage. In the end, it doesn't really matter if you are right or wrong, but what matters is by how much you have gained or lost.

Planning for Investment Risks

We all aim for success in our investments. But success in any investment is a play between returns & risks. You may not have any control on the returns or risks that your investment portfolio actually generates but you definitely have control on making a smart allocation that maximises returns and minimises risks. While planning your investments, 'risks' is often not properly understood and even less planned. This article introduces you to this aspect of planning in your investments.

Planning for investment risks or “Risk Management” is nothing but the identification and assessment of risks followed by smart allocation of money in such a manner that the chances of an unfavourable outcome and/or the losses because of same is minimised. Risk management also involves regular monitoring and rebalancing your portfolio to control such risks.

The steps in any risk management exercise, including investments, would be as follows:
  1. Know the risks faced - identify, characterize and assess threats
  2. Understand the risk involved – determining the extent of risks & probability of occurrence
  3. Identify ways to reduce risks
  4. Prioritize & act on risk reduction measures
  5. Regularly monitor & control risk

The third step involves identifying different ways to reduce risk. A smart person knows that 'not taking any risk' is also risky and that deciding to not take any action is also an action in itself. Risks management strategies can be broadly classified in the following 4 ways:
  1. Avoidance - eliminate or withdraw the source of risk or in other words, do not take exposure to risks
  2. Reduction - mitigate the risks faced by smart strategies
  3. Sharing - transfer or share the risks, i.e., insure yourself from same, if possible
  4. Retention - accept and budget for risks
An investor can adopt any combination of the the risk management strategies while managing his investments. While strategies of Avoidance, Sharing & Retention are largely self explanatory, we take a closer look at the strategy of Reduction, which we believe is much more relevant and meaningful to investors. Risk Reduction would entail strategies whereby you can reduce the overall risks in your portfolio while not compromising on your returns potential. A few of the smart strategies for the same are listed below for your consideration...
  1. Diversification: Even as a child we learnt that we should not keep all our eggs in one basket. This same principle also applies to investments. To reduce risks, we must diversify our portfolio / investments into appropriate mixture of different asset classes, products and companies / sectors, etc. To begin with, we must take a complete picture of our entire portfolio before we start with diversification. As earlier said, diversification can be in various types and ways. For example you may well diversify your portfolio into equity / debt / commodities / real estate, etc. at the higher level then say within equities, you may diversify into direct equities, mutual fund equity schemes, etc. and further even diversify into large-cap or mid-cap, sectoral or theme companies or funds. Diversification must be such that the portfolio is easy to manage and monitor. One of the good ways to diversify, if you are investing directly into equities or debt products, is to invest in mutual fund schemes which may be equity, debt or cash oriented. 
  2. Asset Allocation: While the diversification principle tells you to spread your investments into different asset classes, products, etc., Asset Allocation provides the tool which you can use to properly balance your portfolio to get the best risk-return trade-off suited to your risk appetite. Every asset class has a peculiar returns expectation, risk in terms of volatility of returns and an ideal time horizon for investment. Further, different types of investment instruments respond differently to the changing market conditions, varying political and economic scenario.
    Asset allocation is allocating your investment into different class of assets which usually have no correlation with one another. One can thus be assured, upto an extent, that even if one type of investment doesn't perform, the portfolio will he hedged due to the investment in another type of instrument which may fare well.
    For example, in a booming market, one can increase allocation to the stocks as the strong corporate earnings and relative stability will increase the value of stock holdings. On the contrary, in a rising interest rate scenario; investors would wish to increase their allocation in bonds, reduce allocation in equities and keep a certain position in cash. Hence, modifying one's asset allocation from time to time will help minimize losses in different economic situations depending on which asset class looks favourable or otherwise.
  1. Rupee Cost Averaging: The Guru of value investing, Benjamin Graham, trusted dollar (or rupee) cost averaging as the most effective way for investors to reduce the risk of fluctuation in asset prices. More relevant to investing in equities, rupee cost averaging is nothing but the practice of investing a fixed amount every period (month, quarter, or any period) in an asset. This strategy ensures that you are investing small amounts at all prices reducing the price risk involved to a large extend. Further, as studies show, the periodic investment averages the purchase price of the asset such that the average purchase price is often lower than the market price. SIP or Systematic Investment Plan in a mutual fund equity scheme is one very popular way of investing based on this strategy of risk reduction.

  2. Portfolio Management: The strategy simply requires that your portfolio must be very professionally managed and monitored at regular intervals and that investment decisions must be driven by proper research and analysis. This would keep risks controlled on your portfolio. However, doing this on a sustained basis is not easy for common investors. The investors can however take assistance of experts and professionals like 'wealth managers', 'financial planners' or 'portfolio managers' for managing their portfolios and guiding investment decisions. Often such professionals/ experts have relevant experience in the field and have more knowledge and resources dedicated to this work which cannot be matched by common investors. Investors would be advised to even pay fees such professionals / experts for services in order to get unbiased and high quality services. Over time, one can surely reap many times profits in terms of better investment decisions and reduced risks through professional portfolio management services. 
  3. Hedging: Hedging is another strategy of reducing risks suited and used by more advanced investors. Under this strategy, the investor exposed to risk in one asset class or product would take an opposition position or exposure in say future & option contracts. The idea is that if the investor suffers losses in one investment, it will be offset by a profit in the other. Hedging is very commonly done with derivative products of futures & options.
Risk and return is inseparable so to earn a good return, having a proper risk management system in place is very crucial. Therefore, assessing one’s risk tolerance and time horizon is the starting point to following a proper investment plan and supporting it with risk management techniques. As investors, we must also understand that the risk that we seek to control is similar to everyone but the impact of same on us is subjective in nature and will be unique to our own peculiar situation. In other words, the 'risk' tolerance level for each of us is different and is dependent on one's age, income levels, assets, investment dependency, risk attitude, life-stage, etc. Risk attitude is something that shows how much comfortable are you in investing in products of different risk-return levels. You may like investing in equities and commodities for higher return while others may be interested in minimizing risk and earning a satisfactory return at the same time. In the end, the person who best understands and controls risks will never be on a loosing side. After all, successful investing is more about not making big mistakes rather than choosing winners...

Choosing The Right Investment Avenue

Today you have many options for investment. In fact the options are so many that one often feels confused as to which is the ideal one! Most of us are also unsure of what important parameters to consider before choosing an option. We often consider a few important parameters but ignore a majority of the same. This article shares with you the important parameters that you may consider evaluating before making any investment decision. Please note that we are not considering important personal parameters like risk appetite, asset allocation, etc. here but only looking at parameters from investment product point of view. 
  1. Time Horizon:
    Time is of essence and among the most important determinants for any investment decision. You may easily classify your investment time horizon into different categories like for eg. (i) very short term; less than 3 months (ii) short term; 3 to 12 months (iii) medium term; 1 to 3 years (iv) long term; 3 to 10 years (v) very long term; beyond 10 years. As your time horizons increase, the risk nature of investments can increase from money market instruments to short term debt to long term debt and then increasing portions of equity. Ideally, for a long duration and a growing economy like India, equity asset classes offer much greater scope of wealth creation.

  2. Real Returns: 
    While evaluating returns expected from any investment, we often only look at the returns mentioned or expected. However, we fail to take into consideration factors like inflation and taxation upon these returns. As smart investors, we should always look at Post Tax – Real Returns from any investment. To arrive at this is very simple. Firstly, take the 'gross' returns from an investment – say 8% for 1 year on Bank FD and deduct taxation from this. Eg. If your applicable tax slab is 30% and the interest returs are taxable then the post-tax returns are 8% less 30% or 5.60%. After post-tax returns, the next is adjustment for inflation or price rise by deducting inflation from post-tax returns. Thus, if the inflation is at say, 8% today, then the post-tax, real returns will be 5.60% less 8% or negative 2.4%. Thus, the our investment, as given in example, in reality is going to give you a negative real returns on post-tax basis. This is the recommended method to evaluate any returns for any investment. 

  3. Investment Risks: 
    Investment risks are of many kinds and would arise from (i) markets (ii) nature of asset class (iii) product provider / manufacturer (iv) financial and regulatory environment (v) political climate, etc. Given the nature of asset class, like physical, equity & debt, the risks would vary in nature. Equity risks are mainly market, company & sector driven. Debt risks are generally in nature of credit risk, liquidity, reinvestment, etc. 
  4. Tax Considerations: 
    There are four instances where tax incidence has to be evaluated. First – at time of making investment if the investment is eligible for rebate or deduction. Typically such investments would fall under section 80C, 80D, etc. Second incidence would be the taxability of the income generated from your investments. Income can be broadly in form of interest or dividend income. Third incidence would be that when any investment is redeemed or sold. In such a case, the capital gains , long term or short term, would need to be calculated, depending upon the investment horizon. Fourth tax incidence is that of Wealth Tax, which is more relevant of high networth individuals. Investments can offer tax benefits to you on any combination of these tax incidences. A smart investment decision would be one which will give the best tax benefits and minimum tax liability from your investment.

  5. Liquidity: 
    Investments can be futile if one is not able to liquidate it at times of need or emergency. Surely, life is uncertain and we would not like our investments to be blocked and unavailable when we need it. Liquidity would mean that you can get your investments back easily, within short period of time and without incuring incurring too much of cost or sacrifice of value while redeeming. An investment option offering high liquidity is preferred since one may not only need it at times of emergency but also to make best use of any investment opportunities that may crop up at any point of time. However, having said this, as investors we should be disciplined enough to not liquidate investments often for non-critical or general expenses every now & then just because we can do so. 

  6. Costs: 
    Different investment products have different types of costs attached. Generally, any investment would have any combination of following three types of costs (i) at time of investing new or additional money (ii) during period when investment is active as percentage of investment value or fixed fees (iii) at time of exiting or withdrawing money. Typically we can mention these costs as entry load / expense / exit load. The costs may be calculated as percentage of amount or a fixed sum of agreed fees. Further, costs may be levied for distribution, transaction services or advisory services. There would be also also be costs while making service or operational requests, which are beyond the normal investment costs. Over time, the costs in many products have fallen but still costs are a major factor to consider when one is investing large amounts in products like PMS scheme, liquid funds, insurance products, etc. 

  7. Suitability: 
    There are customised products available in market directed for specific purposes like pension, retirement, wealth creation, safety of capital, child education, etc. Being clear with your investment objective can also be an imporant factor while considering different options. It is however important to be careful since just naming products after some life goals need not necessarily qualify as good investment for that purpose. You may need to weigh small unique features that such products offer before comitting your money. 

  8. Convenience & features. 
    With improving lifestyle and penetration of technology in our daily lives, we would prefer investment products that can be viewed & managed online. While most financial institutions are now increasingly offering such services, off lately, even government schemes & plans have begun such services. Further, one may also like to evaluate other facilities like nomination, third party transferability, loan facility, acceptability as security for loan by financial institutions. While these options may not be of very critical, it can however be a differentiating factor for persons who intent to use these options.
Often the investment decisions made are not based on careful thinking or evaluation on all these parameters. Decisions are majorly influenced by opinions of close friends, influencial persons in family, recommendations by agents, brokers and even by smarter marketing by companies. Evaluating investment options independent of these influencing factors on the parameters given above can most definitely lead to long term financial well-being. If you are not in position of to evaluate these factors yourself, you can surely ask your financial advisor these questions when required. After all, being wealthy in life is not just about making the best investment decisions but also about avoiding bad decisions.

From Debt To Life

In the past 5-10 years, debt has become very easy to acquire and people are tempted by large number of banks would extend good offers to the borrowers. Combine this with rising incomes and aspirations and we have a huge population of young generation that would have at least 2 loans – home and car on their balance sheet. Further, with the explosion of credit cards and change in life style, especially dining, shopping, movies, travel, etc., we are today taking much more debt than we ever did in past. And the only ones who is laughing are the lenders of these credit to you...
With rising interest rates, people who have bought loans few years back now find that the loan EMIs are now a bigger burden, especially with the inflation also running high in recent past. A average household's budget is severely impact and there would be a large population which would be suffering under the burden of loans today. People are now realizing the importance of moving to a debt free life. However, one needs to understand why it is a better idea to get rid of the debt sooner than later and ways to do so. Excessive debt can lead to many problems, such as:
  • Falling short of spending power
  • Not being able to deal with unexpected costs
  • Restricting your ability to take part in social activities
  • Causing stress and depression
  • And many more...
Reducing Expenses:
Reducing expenditure in today scenario is perhaps not an idea but something that all of us are practicing today. While most of would be wise to know how costs can be controlled, there are a few pointer which one may would be better-off considering.
  • Prepare a budget/plan and stick to it: This is the best way to keep expenses in check, be it business or monthly household expenditure. If at the initial stage you plan a budget for yourself, you will not go ;overboard and hence avoid any new loans.
  • Get frugal If you can cut down on unnecessary expenses, you will save more and be self sufficient to meet your expenses. Also, think twice before buying whether you really need the product or is it an impulsive buying. For commuting to office & back, you can pool office collegues to travel together.
  • Spend wisely: There are many ways to spend wisely. Fix / plan maximum number of outings for movies / dinners / small trips / vacations, etc. for month. Use public transportation or pool with colleagues on way to work. Stock more of things you need when you get very attractive discounts. Plan buying in advance for heavy sale discounts seasons. Use public transport for long distance travels.
  • Save and Invest - Save for the rainy day and invest whatever amount you can. It can be extremely useful at any point in future. Even small amounts are
  • Pay all your bills on time – It is an important practice to pay off the bills on time. Delaying the process would add on the amount to be repaid later and also, the penalty and interest costs get added on.
Ways to reduce your debt:
  • Behavioural change: Understanding that you have a debt issue and changing your behaviour and life style accordingly is the first step to reducing your debt.
  • Stop Adding to Debt:: Not taking additional burden of loan is a very basic idea. One may just begin by limiting use Credit cards and instead use Debit cards.
  • Consolidation of Debt: Consolidating debt is another idea which may not reduce debt but would make in easier to manage same. It can help consolidating payment period, EMI and also interest rate for all the different debt that you have. You may negotiate for better deal with your bank manager and rework the repayment schedule for such consolidated loan.
  • Repayment of Debt: Repayment of loans is the obvious way to reduce debt. Often, there are limitations of repayment in terms of the extent of repayment and period after which is repayment is done. Repayment of debt can begin by prioritising the loans on basis of the most expensive loans and/or loans with higher duration which can be paid of first. Addtional payments can be made as and when you get some additional funds or by accumulating small sums of money for few months and then making the repayments. Credit card loans, if any, are generally the most expensive loans, followed by personal and car loans. Home are probably the least expensive of the loans and also offer tax advantages and hence can be paid at least prority.
  • Restructuring of Debt: Another idea is reworking out the loan, in terms of interest rates & repayment period. There is no absolutely no harm negotiating with your creditors or bankers for a better rate or deal. If you make a persistent effort and have good terms with them, a small change will also make a big difference overall.
  • Last Resorts: As last resort to reducing the burden of team, you may take personal loans from amongst your family & friends and repay the expensive loans. Another alternative is the liquidate your existing investments and repay the loans. Typically we can begin with the investments that have the lowest rates of returns, like debt which would probably have lower interest accruals that the interest rates payments on loan. One should however avoid diluting long term savings that may yield good returns, especially equities. Remember that this option is less than ideal because you are essentially stealing from your future.
Understanding the importance is the first step, acting upon it the foundation and following it diligently, a habit. It needs lot of discipline and hard work but one who can practice this will not only have a debt free life, but a care free life.

Saturday, August 20, 2011

Investment Behaviour To Be Aware Of

The title of the article may sound like a chapter from a psychology book. But hardly is it academic in nature. This time around, we would take a look at what goes on in our minds before we take any investment decision. Investment decision making is like a coin with two sides – one which is about about facts, figures, objectivity, planning & so on. This is the heads side of coin. The other side is about how we are, our emotions and our behavior. For most of us, our coins don't often land up as heads. Let us then see at ourselves and look at these behavioral patterns more closely.

Personal Biasness: 
Everyone has a favorite. And the good thing about having favorites is that you tend to know more about them. In investments too we have our favorites and that it where we would be mostly investing. For some it may be equity, for some bank fixed deposits and for some, insurance plans. But the problem really starts when we tend to ignore other better options while feeling comfortable with our choice. Statistics show that a majority of the investors tend to invest only in one, two or at most three products for a particular purpose. Also we tend to be skeptical about new investments and unconsciously find reasons to reject the new ideas. As investors we should always be open for new ideas and investment avenues but not necessarily adventurous.

Herd Behavior: 
Another behavior commonly observed is herd mentality. We often tend to follow others believing that what everyone is doing is right and thus going with them wouldn't harm us. This approach reaches an extreme when we know that something is not right but we still go through it believing that everybody is doing it so when something goes bad, you will not be alone. The sense of our loss becomes less hurting when we know that others have lost too. We also don't want to stand out in a crowd and do things which most of our friends, family members have not done or are not comfortable with. While making investment decisions, this approach or behavior is something we must avoid. If everyone is saying that 'x' is bad or 'y' is good, it needn't be so. Evaluate your decisions independent of what others are doing or saying.

With changing times and growing use of technology and other services, we are now spending less time for things that used to take hours before. The fast paced life has also made us more result oriented and impatient in many things, investments being one of them. However, within investments too, we tend to be more impatient and demanding out of few investment avenues, like equities, while being very easy with others, like say fixed deposits. Playing a good dad or bad dad to different investment avenues is not good. Often impatience leads us to make compulsive decisions, which may not be beneficial. Every asset class is suited for a particular time horizon and equities are for long term. So let us avoid checking our investment every now and think what the remaining money can do for us.

Pleasing others and self: There are also a few among us who are good samaritans. Being good means that you take decisions knowing it may not be best suited to you, just to please or benefit that other person. It is not easy for you to say no. There may be may motives behind this like say relationship, financial assistance, ego or simply charity. But does acting on recommendations by persons, to whom you can't say no, make any real difference to anyone? In doing so, many a times, we also unconsciously are trying to please ourselves and feel good about making such investments. We must learn to say no to investments until we are not very sure about, irrespective of who is behind it. 

Not asking questions: 
There are also few among us who are not in the habit of asking questions. When any investment idea is proposed, we often just ask a few customary questions often beginning with “How is it?” Reasonably satisfied with replies, we rely on the trust and relationship of our adviser who is helping us. Surely, your adviser is acting in your interest, but wouldn't it be really a lot more worthwhile if we could ask all relevant questions before making investments? This would include questions on ideal time horizon, expected returns, risks involved, tax incidences, liquidity, operational matters, past performance, other comparative products, investment costs and so on. Make use of these questions and the next time your adviser will surely bring better options before you and also come well prepared. So next time any investment idea is thrown at you be ready to say “Tell me everything about it”. 

Procrastination & laziness: 
Another very common behaviour observed is that of procrastination. This impacts our financial decisions fairly regularly. Procrastination can be seen in every instance of delaying investment decisions, delaying paper work or pushing decisons to some other time. Our laziness too gets the better out of us. Often, it is because of laziness that we do avoid getting involved in proper research, study of our own needs, financial goals, investment options available and so on. Combine them and we get a deadly combination that can kill good opportunities and harm our financial well-being over time. You may not see any big impact at any point of time, but they are always there, eating away your few rupees every now and then. 

Overriding emotions: 
The last behavior but also the most pressing one is where we let our emotions get the better of us and impact our investment decisions. There are three emotions that we will talk about here – greed, fear & hope. Greed would be like buying when the prices have risen, looking at the past performance or the returns others have made or still holding on for more when the prices have already risen. Greed would also make us go on fishing trying to catch a big fish from a water we cannot see. The big fish or the next multi-bagger, hot tip, often does not turn up. At the end of the day, we waste more of our precious time and money trying to get one than from we benefited, even if we caught one. Fear is another big emotion to be beware of. It often makes us avoid good opportunities when markets are not doing good, for the fear of further falls. A sense of negativity prevails and we tend to believe worst is yet to come. We would also tend to sell and windup our investments in order to salvage whatever we can at preciously the time we should be acting in the opposite manner. Not only do we end up loosing money but we also end up loosing money that we could have made during these times. Any bad experience in past also makes us overly cautious and we blacklist the entire investment class for ever, often to our own loss. Hope is last of the big emotions that we pay to carry. Often it would make us keep holding in our long time, favorite investments hoping they will recover to the past highs. A sensible, objective analysis should be made each time any emotion overbears itself on our thinking. Emotions, after all, carry no value in the investment world.

Knowing and acknowledging the presence of these behavioral traits within ourselves would help us in avoiding decisions taken immaturely. The better we know ourselves, the better we can be objective in our decision making. Consciously keeping our emotions aside over time will see that our investment coins lands heads up more often than not. It is this process by which you graduate from a normal investor to a smart & shrewd investor.

Friday, August 19, 2011

Retirement Planning: A Must For Everyone

India is a country where traditionally people are not oriented for retirement planning in finances. There is a prevalent culture of joint family and the older generation expects the next generation to take care of them in the old age. Surely there is some form of retirement savings being done. But it falls far short of the actual need in absence of any proper planning with 100% financial independence. However, today there is an increasing need felt for retirement planning especially among those in the middle age group.

What is the need to plan/save for retirement:
Here are some of the reasons why the growing need for retirement planning is felt.
  • Post-Retirement Life: Over the years, the average life expectancy has increased to almost 70 yrs. However, it also likely for one to live almost for 85-90 years since today. For a person, retiring at say age 60, it is likely that 30 years of his would be in retirement. This thought itself arouses a shock and concern, and any sane person would feel the need to plan wisely for the future. Post retirement, one would need to provide additionally for medical care, costs for any operations of surgeries, for any passion or hobby to pursue, etc. With rising costs of living, urbanisation & growing needs, factored with inflation for 30 years: the need for starting to save immediately for retirement assumes great significance.
  • Self-Dependence: Earlier after retirement, children were supposed to assume the role of financial care-taker in times of personal/medical emergencies but off late people realize the importance of planning for retirement during their working life only. This has also to do a lot with growing complexity of life with multiplicity of needs, increasing importance to money, ambitions of the younger generation coupled with the desire for total freedom in decision making, etc. To put it in simple terms, the working generation today wish to have a dignified & independent retired life without taking any chances on the next generation for financial support & care.
  • Urbanisation & Migration: The rapid urbanisation is reshaping how we live our lives. Trends show that there is a change from the joint family system to nuclear family system due to many factors. The houses are becoming more expensive yet smaller. A large number of the working population is also migrating to the bigger cities for better work opportunities, largely giving rise to the culture staying away from the parents.
  • Uncertainty of pension benefits: Although you may get pension benefits and the amount compulsorily saved in public provident fund can provide some support, yet it may not be sufficient enough. Moreover, in India, the states do not provide any social security for the retired people, so it becomes even more important to plan for retirement.
What is Retirement Planning?
Retirement planning is the process of arranging finances to meet expenses during retirement period. The idea is to collect enough retirement kitty so that you get financial independence in managing your personal expenses. The important considerations that go into planning for retirement are...
  • Financial assessment: What is the current income, expenses and savings and what amount needs to be saved to sustain the kind of lifestyle he/she wants at present and after retirement. Other inputs to consider are the kind of disposable assets & liabilities would exist after retirement and any business, hobby or other post retirement expenditure or income is foreseen.
  • Goal Setting: It involves realistic goals about the standard of living that one wants post retirement and what should be the retirement income. Often, fixing the retirement age is also dicey as people may wish to retire early but may not be financially viable decision.
  • Financial Planning: It involves ascertaining the retirement kitty requirement and managing resources to build the retirement kitty. It also involves managing the retirement kitty smartly after post retirement so as to comfortably provide for expenses during the retirement period.

Building Retirement Kitty:
Key inputs like retirement age, expected household expenses, retirement period, inflation, returns on retirement kitty, returns on existing or new investments to build retirement kitty, existing assets & liabilities and the savings potential are used will arriving at the retirement kitty. Each of the input stated above can impact the retirement kitty need drastically. While some of the inputs are in control of the person concerned, some, like inflation & retirement age are out of control. Building a retirement kitty is about taking smart decisions from today itself before it becomes too late. Some important factors that can be effectively managed and would help in retirement planning are:
  • Create a retirement plan: Identifying your retirement kitty need, is very crucial. You may approach your financial advisor for the same. You may also try some of the online tools for same but it may match your exact needs.
  • Save and invest regularly: Saving regularly, beginning now, is most important, even if you haven't yet prepared your retirement plan. Chances are that you would have saved only a fraction of the retirement kitty need when you do the retirement planning in future. There is perhaps no option than to save the most that you can in appropriate asset class depending upon the years remaining to retirement.
  • Diversification and Asset Allocation: One should diversify the existing investments and divide the savings into equity and debt asset classes. We must remember that equity asset class in long term can significantly contribute to your retirement kitty, if adequate savings are done in early years of one's life. In many cases, debt investments done for retirement would never be sufficient for your true retirement need. Deciding the right asset allocation is very critical to the success of your retirement plan.
  • Disposal of assets: When retirement actually arrives, there can be other possibiliites explored like disposal of assets (property) by sale or rent to meet retirement kitty need. There is also a trend of reverse mortgage wherein you receive payments from financial institution against your existing house which you mortgage to them but continue to keep possession for your retired life.
Retirement kitty is something which is doesn't easily figure on top of your 'list of goals'. Observations show that the more you delay planning for your retirement, increasingly, the dream of having an independent, dignified retired life becomes blur. Retirement planning can be easy when you are in the initial 5-10 years of your working life and is perhaps the best years to start planning for retirement. Quite often people are shocked to hear the retirement kitty requirement and mostly it is too late to do anything tangible. As investors we strongly recommend that you start planning & for your retirement at the earliest.

Thursday, August 18, 2011

Guaranteed ways to lose money

We all have read a lot about various financial products that help you in creating and protecting wealth. But there also exist lot of products or say practices which often lead to wealth destruction. Each and every product and asset class has it's unique features, but it is important to understand that every asset class is different from the other and is having it's own peculiar risks. If you play with an asset class in a wrong way, it can destruct your wealth in a big way rather than creating it for you. Let's have a look at some of the practices, which help in losing money.
  1. Stock Market speculation: Stock Market speculation or Day trading, simply put is the activity of buying and selling the shares for a very short duration without taking any deliveries with a purpose to gain from the daily volatility in the stock prices. Day trading is the most common practice followed by new entrants into Equity investing. It is the most exciting feature as the prospect of making millions by sitting in front of the screen and just guessing the right prices is a mouth watering one. Always remember that fluctuations in share prices during the day does not truly represent the functioning of the company. The person who makes the most money through day trading is the broker. For an investor, the chances of making money in day trading are as good as winning a toss. The greatest investors in the history like Warren Buffent, John Templeton, etc. have created wealth not by guessing price movements but by making fundamental long term investment decisions.
  2. Investing in FD's which double your money over 6-8 years: Investors are obsessed with the safety of their investments and jump on any product giving guaranteed returns. Fixed Deposits as an asset class are good for short term investments of 1-2 years. By doing an FD for a tenure of 6-8 years investor only ends up losing money as the value of money also keeps on declining due to inflation. So, if you have got a return of 8.5% on your FD and the inflation during the period was 8%, your actual rate of return is 0.5%. Take taxes into account and your return is negative. So, if you are investing for 6-8 years you are increasing your negative returns for that long a period.
  3. Derivative Trading: Futures & Options are available in the stock market for the purpose of a better price discovery and for hedging your investments. Unfortunately, these derivatives are used as tools for making quick money and they turn out to be more dangerous than day trading. In derivative trading you can trade for 2-5 times more than the money you have. So if you are having Rs. 100, you can trade for Rs. 500 through derivatives. So with the same investment you can make 5 times more profit (and conversely 5 times more losses, wiping out your capital). Derivatives are for use of professionals and playing in them without their guidance can be highly dangerous.
  4. Keeping cash: Another Myth for keeping money safe, is to keep it in cash. Cash not only has it's own risks for storage but is also the only asset class which gives “0” returns. The value or the purchasing power of your cash goes down on a continuous basis due to inflation. This can be best understood, if you list down the items which could have been bought in Rs. 100, 10 years back and the price of those items now. You should keep cash only for the purpose of ensuring your basic needs. With the advent of ATM, cash is now readily available round the clock at an ATM near you, so better to keep it in your bank account rather than keeping huge quantities at your home.
  5. Using your credit card as free money instrument: Credit cards are most widely used instruments these days in place of cash. It gives lot of convenience as you don't need to pay at the time of purchase. Infact, you enjoy an interest free period of upto 45-60 days on your purchases. But many a times, people tend to overspend on the credit card. It is important to pay your dues back on time, else you can be subjected to interest rates as high as 3.5% compounding per month (which works out to an annual rate of 51% interest). Never fall in the trap of skipping your credit card payments or paying “minimum amount due” as you start getting charged heftily on all transactions done then on. The interest rates are so high that if you default you might end up paying higher interest than the principal amount. Though, if you keep paying on time, there is no better option than a credit card. Besides you also keep earning reward points for the money spent by you.
It may take you long time to create your wealth, but to lose it can be done in a matter of seconds. It is better to stay away from practices that can erode your wealth and make good use of every product available in the right way. That way, we will not only save wealth but also will be able to sleep peacefully.