PART5: Principle Factors affecting Investments
Do you know where all are you invested? Are those investments enough to cover your goals? What is the purpose of the amount invested? How do Inflation, Compounding, Taxation affect your wealth creation?
In the last few blogs we looked at Insurances and Emergency funds which would help cover the risks and keep your investments safe. We will now move on to take a look at various factors that we need to consider while planning our investments and seek answers to all the questions above!
In this blog, we will focus on
- Goals
- Inflation
- Power of Compounding
- Taxes.
1.Setting your financial goals:
Like any other goals in our life, our financial goals have to be ‘SMART!’ — Specific, Measurable , Achievable, Realistic and Timebound.
Without goals, one can never determine if the investments being made are good enough or not. The amount may appear large but just vanish when you dip into it for any major requirement. So to systematically plan your investments and manage them, it is very important to associate each of then with a goal.
Below is a quick view of how goals can be classified in different timeframes
So depending on what your goal is and considering your timeframe, you can plan your investments.
For eg. for a newly married couple, a vacation abroad could be a short term goal, buying a house — medium term and Child’s higher education — long term.
We will look at what is ‘Risk Appetite’ and different ‘Investment instruments’ in upcoming blogs.
So one can follow below steps with regard to goal setting:
a. Identify your goals
b. Classify your goals as per types above.
c. Calculate the amount required for each goal.
d. Invest according to your risk appetite considering appropriate investment instrument as per your goal type.
However, sometimes specially when you are in your early 20s, you may not have a complete visibility into all your goals and yet have surplus to invest. In such cases or at any point in life you have a surplus and no goal it is absolutely fine to label it as a miscellaneous investment and grow the money rather than just spending it for no real purpose.
2.Inflation:
What is inflation?
Inflation is the rate of increase in prices over a period of time.
For e.g. a pen costed ₹10 in the year 2010, ₹15 in 2015 and ₹22 in 2022. So the money required to buy the same pen has increased over years. This is inflation. To put it in other words, the value of money decreases over the period of time. In 2010, ₹10 were enough to buy a pen but in 2022 you would need ₹22 to buy the same pen.
How does inflation affect your investment returns?
Going by the definition of inflation above, let us assume you are holding ₹1,00,000 as idle money. Assuming an inflation rate of 7% per annum, the value will fall by 86.86% in 30 years, turning ₹1,00,000 to ₹13,376. That means your 1,00,000 today would be worth only 13,376 after 30 years.
This leads to a reduction in returns realized from our investments. When accounted for inflation, most investments like Fixed Deposits rarely create wealth since they do not offer returns that beats inflation.
While choosing any investment instrument, we should always ensure that the rate of return is more than rate of inflation.
If not, then that particular investment would not help you grow your money and in fact, reduce the value of your money invested owing to inflation.
Real Return = Nominal Return (actual return) — Inflation
3.Power of Compounding:
Compound interest is the eighth wonder of the world. He/She who understands it earns it and he/she who doesn’t pays it
Confused? Well, let’s make it simple with the help of an example.
Now, if you look at the above table , we see 2 cases — one is year on year returns through simple interest and other through compound interest.
In year1, the initially invested ₹100 invested at 10% would become 110 in both cases. So in the first year there will be no difference in the returns generated through Simple and Compound interest.
However in Year2 you would get ₹121 from Compound Interest and ₹120 from Simple Interest. Year on year this difference would increase and one would end up with a handsome amount generated from compound Interest. Now why is there such a remarkable difference?
The difference is due to the fact that, in case of compound interest in Year2 , you earned 10% on ₹110 that you had accrued at the end of Year1. However in case of simple interest, you earn 10% on ₹100. And for simple interest every year you would earn interest only on the initial ₹100 you have invested but in case of compound interest you would earn interest on the interest you have accrued in the previous year as well making it a magical factor in investing.
Save a little and invest it at the right place for a long time to generate handsome returns. You can create a corpus in crores by the time you retire , if you invest a fixed amount diligently over a long period of time.
Above table shows how ₹10000 invested monthly over 30 years can fetch you approx. 3.53 crores! You can use any compounding calculator available online to calculate as per your needs and invest accordingly.
So to sum it all, you are always subjected to compounding . You use the power of compounding by investing regularly to create wealth or you take EMI’s and allow the banks to take advantage of compounding and get rich. Now choice is yours!
4.Effect of Taxation on investments
It is very important to consider the effect of tax on your investments since that directly affects your actual returns. Taxation rules vary as per different investment instruments. They vary for debt, equity, dividends, capital gains, real estate over different period of years. We will get to the details when we discuss various investment instruments in upcoming blogs, however as an important takeaway here one should always understand the tax implications before investing in any instrument.
Conclusion:
Set your goals, classify them and invest accordingly
When choosing any investment instrument consider the impact of Inflation and Taxes
Use the power of compounding to create wealth over a long time horizon.
Disclaimer: The calculations above are designed only for information / education purpose. Kindly do not consider this as an investment advice. Do your due diligence before making any investments.