How to Invest and Live a Financially Healthy Life

Basics of Investing and How to Get Started - A primer on Investing for Beginners

Are you someone who is new to investing? Are you confused by the endless financial jargons and what seem like made up words thrown at you by business news channels, newspapers and social media? Are you someone who wants to invest but doesn't know how to or even where to get started?

If you answered yes to any of the above questions, then you're not alone.

Only about 1% of India's population (1.3 crore) invests, compared to about 20% in countries like US and UK.

In 2019, out of 130 crore Indians, only 5.78 crore filed income tax returns. Out of this 5.78 crore, 75% or 4.33 crores reported an income below 5 lakhs.

Source: https://zerodha.com/z-connect/rainmatter/beyond-misleading-trading-turnover-numbers-the-actual-size-of-indian-capital-markets

So its not surprising that majority of Indians struggle to manage their personal finances. We are inherently great savers and as a country have one of the highest household savings rate in the world, but we aren't great investors.

We are taught very little about money and almost nothing about investing in either school or even at college. When we do start earning as adults, it seems like a daunting task to understand this completely alien world of finance. More so, family wisdom dictates that one should opt for fixed deposits rather than invest in capital markets as fixed deposits are 'safe'.

Those who can afford to, hire financial advisors, while those who can't, usually give up after experiencing losses and settle for low returns by investing in bank fixed deposits. (By the way, fixed deposits may have worked for previous generation when interest rates were north of 15 to 20%, they do not work today. Post tax return on a fixed deposit is barely enough to beat inflation, so over a longer timeframe you are actually losing money by investing in a fixed deposit.)

In this article, I will try to bridge this knowledge gap and layout a simple to understand framework that will help you get started with investing and managing your personal finances.

To understand the world of investing, you need to first understand three very important concepts.

1. The more risk you take, the higher your returns can be (and equally larger losses)

2. The more effort you are willing to put in managing your money, the higher your returns

3. Compounding is a hard to imagine concept but if used effectively can create enormous wealth over a long period of time, with very little investment

Lets understand each of these a bit more in detail.

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The more risk you take, the higher your returns (and equally larger losses)

Every investment carries some amount of risk. The more risk you're willing to take, the higher the returns are promised to you.

Take for example, you have two friends - Ram and Shaam. On occasion, both of your friends have asked you to loan them some money. Ram has always paid you back in full and on time, while Shaam still owes you from that time you loaned him about 3 years ago.

In May'20, when Covid was at its peak and India was in lockdown, Ram and Shaam came knocking at your door with a request to loan them some more money for emergency relief.

Now you being a good friend decide to help them out by extending a loan with an interest rate on it.

Would you charge the same interest rate to Ram (who has always paid you back in full and on time) as Shaam (who has never paid you back and still owes you money from a previous loan)?

If your answer is no, then you have understood this very important concept.

Extending a loan to Ram carries less risk as Ram has a history of paying you back on time. While extending the same loan to Shaam is riskier as Shaam has historically never paid you back on time and most likely will not pay back this loan on time as well.

Banks follow the same concept while extending loans to you. They look at your credit history (record of what loans you have taken and if you have paid them back on time) and decide the interest rate on the loan accordingly. The higher the risk, the higher is the interest rate.

Similar concept plays out in investing.

If you're willing to take no risk with your investment, you will be more inclined to invest your money in a bank fixed deposit with very low but predictable returns. While if you're someone who can take more risk with his/her/their investment, you will be more inclined to invest in stocks or mutual funds and expect a higher return than a bank fixed deposit as you're taking on more risk.

Below is a table depicting risk and returns for some of the common investment options available:

Your goal is to minimize your risk while maximizing your returns. In finance this concept is known as risk adjusted returns or alpha, more on that later.

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The more effort you are willing to put in managing your money, the higher your returns

Investing in a boarder sense can be divided into two types - Passive and Active.

Passive investing requires very little effort on the part of the investor. Its a concept that has become popular in recent years and passively managed investment funds are gaining market share compared to actively managed funds.

Examples of passive investing is buying index funds (funds that track a market index, in case of India these will be Sensex and Nifty) via SIPs every month. You can set a reoccurring investment of as low as Rs 100 a month into Nifty and forget about it. Over a period of 20 years, you should get an average yearly return anywhere from 12 to15%.

Active investing on the other hand, tries to beat the market returns by actively buying and selling stocks as the markets rise and fall. Most mutual funds in India are active funds. Active funds have a higher expense ratio (money that is deducted from the returns generated on your investment by a mutual fund) as these are managed by a team of investment professionals and well, they need to earn as well to keep the lights on. Another example of active investing is managing your own stock portfolio. This approach is obviously riskier and requires more effort from an investor. However, if the investor knows what they are doing, returns from this approach can also be extremely rewarding.

Your goal should be to maximize your return while minimizing your effort.

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Compounding is a hard to imagine concept but if used effectively can create enormous wealth over a long period of time, with very little investment

Compounding is the only reason you should be investing. As human begins we aren't very good at intuitively understanding the concept of compounding over long durations. It's hard for us to comprehend how compounding can lead to extremely large numbers when repeated consistently over a large period of time. Our brains are not wired to understand exponential growth.

In simple math it plays out like this:

6 + 6 + 6 = 18
6 * 6 * 6 = 216 (this is compounding and exponential growth)

Compounding enables your investment to grow faster towards the later stages of investment cycle than it does at beginning. Take this for example, consider you are able to achieve 13% yearly returns (this is the rate at which Nifty and Indian stock market has grown over the last 20 years), your money would double itself every 5.5 years. So in 22 years you would have multiplied your money four times, once 5.5 years, another 5.5 years later and then again and once again at the end of another 5.5 years.

What would be your investment amount if you had invested Rs 10 Lakhs at the beginning and compounded it at 13% every year for the next 20 years?

It would be 1.33 crores.

Magical isn't it!

Maybe that's why Albert Einstein referred to compound interest as the eight wonder of the world.

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Now that you have understood these important concepts, lets figure out how to actually invest while minimizing effort and risk and maximizing your returns.

Minimizing Risk

To minimize your risk, you first need to understand your risk appetite. Every one has different risk appetite based on their circumstances. A young 21 year old who has no dependents can take more risk compared to a 30 year old who is the sole bread earner for their family. If you are someone with a lot of debt on hand, your risk appetite will be far lower than someone who has no debt. Calculating risk appetite is a tricky and personal affair, only you can judge your risk appetite for yourself. Most likely you will end up either over-estimating or under-estimating your actual risk appetite so take time to self evaluate your current financial situation, talk to family members and then decide your actual risk appetite.

To guide you in making this decision, you may refer to some of the below general rules.

Young, no dependents, stable income → High risk appetite → More allocation to stocks

Old, many dependents, not stable income → Low risk appetite → Low allocation to stocks

Minimizing Effort

Once you have identified your risk appetite, you now need to decide how much effort you want to put in towards managing your investments. If you're someone who wants a no frills investing approach and doesn't have time to read about economy, find investment trends etc. then passive investing is the way to go.

On the other hand if you're someone who wants to read and learn about investing and can devote 15-20 hours weekly, then active investing by purchasing direct stocks is the way to go.

For most of us, passive investing into low cost index funds is ideal. It’s the boring way to invest but as shown in the example above can still net you decent 13% returns every year for over 20+ years.

Maximizing Returns

So by now, you have narrowed down on your risk appetite and decided how much effort you want to put in towards managing your investment. Your next step is to identify where and how to invest.

For someone looking for safe and assured returns, your choices are limited to

1. Fixed and Reoccurring Deposits → These are offered by banks and carry very low rates of return

2. Government Bonds → These are guaranteed by Government of India and generally provide a tiny bit higher return than a bank fixed deposit. Post office deposit returns can also fall under this category.

3. Corporate Bonds → These carry a higher risk as they are issued by a company and carry a higher rate of return compared to Fixed Deposits and Government Bonds.

For someone looking to invest in stocks, your choices are as follows:

1. Passive Index Funds → As described earlier they copy the returns generated by the entire stock market index like Nifty and Sensex (for India). Since these are passive in nature, the expense ratios on these are very small and these should be your ideal investments for someone looking for a no nonsense low effort way to invest.

2. Actively Managed Mutual Funds → These are your typical mutual funds available to invest via SIPs. For anyone looking to invest in a mutual fund, you need to be careful about a few points:

   a. Rebalancing → Every year you should be looking at your mutual fund returns against the market and if your mutual fund generated lesser returns for you than the index, please sell it and reinvest your money someone where else.

   b. Direct vs Regular Funds → Please do not, never, under any circumstance buy a regular fund. Every actively managed mutual funds has two offerings - a regular type fund and a direct type fund. Regular funds have higher cost structures and expense ratios (the money deducted from your yearly return) as they include commission cost, compared to a Direct Fund. These costs can set you back as high as 1% in total return every year, which again compounds and adds up to a lot over a course of 20 years.

   You can read more about direct vs regular mutual funds here.

   c. Overlap in underlying stocks → Please do not buy more than 3-4 mutual funds at a maximum and please always check if any of the funds you are investing in have an overlap in terms of underlying stocks that the fund holds with any other fund you're investing in. You can use this tool to quickly check what percentage of stocks overlap between the funds you are investing in.

3. Stocks → Unless you're someone who doesn't follow economics, read a lot about investing, understands concepts like diversification, stock betas, etc. and cannot allocate 10-15 hours a week to research and learn about the companies they want to invest in - then please stay away from investing in direct stocks. Investing in stocks is as much about patience, controlling your emotions of fear and greed, as it about research and learning about the companies the stock represents. Every stock represents a company and unless you are willing to spend time to learn about the company and industry that the company operates in, you're better off investing passively in index funds.

4. Options Trading → Options are sophisticated financial instruments meant to be used by professional traders. In my view, these shouldn't even be available to the average investor to invest in and unless you understand concepts like Vega, Gamma, Delta, Theta and Rho - please stay away from them. Anyone who tells you that they can make you a quick buck by investing in options is lying to you and is using your money to gamble. More wealth and fortunes have been lost by investing in options than made from it.

I hope this article helped you understand the basics of investing and how you can get started with an investment plan for yourself.

Until next time.

Peace,
Tar

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