Don’t just save but rather invest to create wealth
We Indians are very good at saving. However, when it comes to making investments, we are driven more by sentiments. The reason we are good at saving is that since childhood, all kinds of lessons on saving are embedded into our system. However, what is not taught is how to go about investing the money saved.
So let us understand the difference between saving and investing and how to move the money towards investment.
During our childhood, we saved money in a piggy bank as we knew our money was safe there and later on, we could take it out to buy a new bicycle, new cricket bat, etc. As we have grown up now, the savings habit has remained intact. However, the instruments into which we are saving have changed from piggy banks to largely savings bank accounts, largely to ensure that our money is secure. By keeping your savings in these instruments, you will be in your comfort zone of safety but your savings are likely to get eroded by the effects of inflation. What this essentially means is that in real terms, the value of your money would reduce over a period of time.
Hence, savings needs to be transformed into investments and we need to beat inflation; only then we would truly enjoy a return. This excess return (return – inflation) is what is called a Real Return. Our aim at all times should be to ensure that we optimize and not maximize our real return. This real return will enable us to ensure that we achieve our financial goals like funding our children’s education and marriage, purchasing property and comforts like cars, creating funds for retirement, enjoy vacations, etc with ease.
Factors to be borne in mind whilst investing:
Time Horizon: If the time horizon of the goal is long term, then one should invest in asset classes like equity as the volatility associated with this instrument usually spreads out/ reduces, over the longer run. The other way round is if the time horizon of the goal is short term, then you should invest in asset classes like fixed income, as the volatility of returns in fixed income products is lower than equities, in the short run.
Appropriate Inflation: Also, inflation depends upon the specific goals of an individual. For example, in the case of a goal such as children’s education, inflation is mostly in the range of 11-12% and hence, one needs to invest in higher real return generating assets like equities, in order to be able to achieve the goal. Similarly, when one is planning for retirement, one could consider the average CPI of the past 10 years or the current CPI, whichever is higher.
A common mistake made by many is to compare the returns without considering the impact of taxation. For eg: interest on bank fixed deposits is taxable; whereas an investment in equity, held for more than 1 year, attracts Nil tax. Thus to have a meaning-full comparison, one should consider post-tax returns and not pre-tax returns.
The data below shows how various asset classes have performed over different time horizons, both on a pre-inflation basis and post-inflation basis:
Assume that an investment of Rs. 1 lac is made.
Thus, as you can see from the data above that equity has out-performed all the other asset classes mentioned above, on a post-tax basis, and has also earned positive real returns in the approx. range of 1.3%-6.6% p.a. In case of a savings bank account and bank fixed deposits, the real returns are negative over all the time periods. Where Gold is concerned, it has been able to achieve real returns of approx. 0.9% and 1.6% over 15 years and 10 years, respectively, and has earned a negative real return over other time period of 1 year and 5 years.
Every investor would like to see his/her portfolio earning higher real returns, which will lead to wealth creation. However, that doesn’t mean that you should invest 100% of your entire portfolio into equities as the possibility of great returns would come with equivalent amount of risk and volatility. Instead, the portfolio should be well-diversified across different asset classes, which will help to reduce the volatility in the portfolio while potentially optimizing your portfolio return for the amount of risk you are willing to take. This is called asset allocation.
Bottom line: One should focus on or target earning positive real returns (returns over and above inflation), which will, in turn, lead to wealth creation. If one invests in instruments earning negative real returns (returns below inflation), it will lead to a depletion of wealth.The exposure that you should take in different investment instruments depends upon your financial goals, investment time horizon, the importance of each goal, etc. Lastly, all these parameters should be viewed together and not in isolation while making an investment decision.