Investing is setting aside money now for the future. This is crucial if you want to be rich. Investing is not about money right now. You can invest in quality education and enjoy a great career. The investment is money spent for a good degree and a well paying job after graduation is the returns.
Investments earn money through appreciation (Rise in the value of the asset), interest payments (This is in the case of fixed income instruments), and even dividends in case of mutual funds and stocks.
You can’t talk about investments without talking of inflation. Inflation is the rise in the value of goods and services with time. Inflation eats up returns from the investment. You end up getting less than what you must. This is inflation risk.
Risk and return are like two sides of a coin. Risk is basically you end up with higher or lower returns than expected. We talk about lesser returns than expected. There are plenty of risks like inflation risk, interest rate risk, business risk, exchange rate risk, reinvestment risk and currency risk which impact returns.
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1. Start Early
If you want to be rich, start investing early. You get to enjoy the power of compounding or return on return. When it comes to fixed income its compound interest.
What is compound interest? Compound interest is the addition of interest to the principal.
A = P (1 + r/n)^nt
A = Final Amount
P = Initial Amount
r = interest rate
n = number of times interest is applied per time period.
t = number of time periods elapsed.
How is compound interest calculated?
P = Rs 1,00,000.
r = 8%
T = 5 years.
N = 4 (Interest is compounded every 3 months).
A = Rs 1,48,595.
2. Make a Financial Goal
A financial goal involves time and money. You need to set aside money for the financial goal and a time frame to achieve it. A common goal is buying a car. The financial goal is buy a car of Rs 5 Lakhs in 3 years.
3. Diversify your investments
The heart of a portfolio and an investment is diversification. In simple terms don’t put all eggs in a single basket. Diversify the portfolio across equity and debt. Invest in stocks, mutual funds, FDs, debt funds, gold and government securities. Have at least 5-10% of gold in the portfolio. Take a term life insurance plan to protect loved ones on an untimely death. Health insurance is a must to meet emergency medical expenses.
4. Invest for the long term
This is the heart of any investment rule. Invest for the long term. Equities are a great investment only if you stick for 5-7 years. Invest in mutual funds through SIPs. This is a method of investing in mutual funds where you invest small amounts regularly in mutual fund schemes of choice. You then stay invested for the long-term and make huge profits. Don’t stop SIPs when markets crash. This is an excellent time to increase SIPs and enjoy both average costing and compounding returns.
5. Look at real rate of return
Real Rate of Return = (1+nominal rate/1+inflation rate) - 1
Most people look only at the rate of return. You need to focus on the real rate of return. This is the inflation adjusted rate of return.
Let’s say the FD offers 7% return. The inflation rate is 4%. What is the real rate of return?
Real Rate of Return = 1+0.07/1+0.04 – 1
Real Rate of Return = 2.88%.
So, even though you get 7% FD interest, the real rate of return is just 2.88%.
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