Thursday, 25 April 2013

Investment - The Wealth Creation Tool

We keep hearing about financial planning every now and then. We keep talking about how to make our money flow into the right channels and to make it work of us. For most of us, all this stops with the monthly budgeting exercise where we allocate some amount for our regular expenses and the rest goes into various savings and investments without putting in a second thought to it. The result is that more often than not, the money that we save goes into inefficient channels because we got the balance wrong in the first place.

In our post Becoming Rich - Its Possible!! we tried to put some structure to the concept of financial planning by dissecting the idea into its constituent part. One of the major parts of financial planning is investment. In this post we will try to give some shape to our vague idea of investment.

Investment :

Simply put, it provides a cover against the depreciation in the value of your income and savings so that we can meet our expenses while not being affected by inflation.

Let’s take an example. Say you have Rs.10000/- with you as principal amount remaining with you after expenses which you want to save or invest. Let’s say that you have decided to put all of that into a 5yr FD which earns you a compounded interest of 8%. In the duration till maturity, if the inflation has been at a level of 10% on an average, then at the end of the FD term your principal would have earned you a return of 2% negative. There is a net loss. This means, the investment option which we chose for a 5yr investment period was an inefficient one. Surely there would have been other options which singularly or as a combination would have given enough returns to keep up with the increase in price rise which we call inflation.

Inflation Adjusted Return :

Also known as Real Rate of Return, it is the actual return that you get from an investment. In the above case the Inflation Adjusted return is -2%.

When you choose your investments you should try to estimate the inflation adjusted returns.

You can use various investment options like

  • Bank and corporate deposits, Post Office Savings Schemes, Monthly Income Schemes etc. which give fixed interest
  • Property
  • Stocks/equity
  • Mutual Funds
  • Gold and precious metals

or a combination of all to achieve your objective and earn good returns.
Also, except for equity and equity linked investments like Mutual Funds, all other options attract some form of taxes. This too need to be factored-in while calculating the net returns from an investment.