There are opinions and then there are facts. Facts are not dependent on time, location or market cycles. In other words, these facts will hold true whether you live in India or North America, whether you were born in the 16th century or the 21st century, whether you are just entering the work force or you are about to retire. When you follow rules based on facts success is inevitable. The rules that we will cover in this blog have a stamp of approval from the leading investors across the world, so you cannot afford to ignore them if you want to achieve financial success.
Golden Rule of Investment #1: Invest for Real Returns
This is a cardinal rule that was preached by none other than Sir John Templeton, one of the greatest investors. Real returns mean the return on invested amount after taxes and after inflation. However, majority of the investors invest for just absolute returns. Any investment strategy that ignores the effects of inflation and taxes will give sub optimal results. Let’s delve a little deeper.
For example, if inflation averages 7%, it will reduce the buying power of Rs 100,000 to approximately Rs 50,000 in 10 years. But 7% is not a hypothetical number, India’s average inflation rate from 2008 to 2018 was 7.4% a tad above 7%.
The other critical component that impacts the returns on investment is tax. There are different categories of taxes based on the investment asset class. We are all familiar with how interest generating classes like fixed deposits are taxed but what about profits we earn through sale of capital assets like stocks, mutual funds, gold, and property? The taxes for these assets are classified as capital gains. But the important and interesting part which many are not aware of is that any asset that is categorized as equity such as stocks, equity mutual funds etc. are taxed at 0% if the capital gains for the fiscal year are below 1 lakh and the investment holding period is over 1 year.
For example, if you are in the 30% tax bracket, and invest Rs 10 lakhs in an equity fund and make a modest capital gain of Rs 80,000 on selling after a year, you will have no tax liability. On the other hand, had you invested the same amount in a fixed deposit, giving similar returns, you would have had to pay a tax of approximately Rs 25,000, pulling your total gain down to Rs 55,000.
So, you need to factor inflation and understand the tax implications of your investment fully before making an investment decision else, you will leave money on the table.
Golden Rule of Investment #2: Manage Risk
As Warren Buffet puts it, “Rule #1, never lose money. Rule #2, never forget Rule #1.” Simple to understand but interpretations can be different. If we take the above rule to mean that we should avoid risk at all times then, we will continue putting money in sub-optimal assets like fixed deposits and insurance products like endowment plans. On the other hand, if the interpretation is to manage our risks by being aware of it, the investment strategy would be completely different.
Majority of us tilt towards risk avoidance and I believe the reason is we do not understand the components of risk. There are two components of risk as it relates to investment: Probability of Loss and Consequences of Loss
We usually invest based on the probability of loss and do not consider the consequences of the loss. For example, if you have a sudden windfall of Rs 50,000, the consequences of loss would be insignificant if your total net worth is Rs 50 Lakhs. In this case, you may entertain the thought of investing the amount in equities or other market linked assets. On the other hand, if you only care about the probable loss of capital, you will make the default choice of putting the entire amount in fixed deposits or other fixed income products, where the returns are guaranteed but sub-optimal.
Another element that has a bearing on risk is your investment timeline. For example, if you need the money to fund your child’s education in less than 3 years it may not be a good idea to invest in equities or real estate because the consequence of loss is very high irrespective of how the market is doing.
In other words, instead of avoiding risk, manage risk by weighing multiple factors before deciding on which asset class you want to invest in.
Golden Rule of Investment #3: Spend Time in the Market
Numbers have repeatedly shown that “time in the market” beats “timing the market” year in and year out. The reason is simple, when you spend time in the market you leverage the principle of compounding a concept, in which when money is left to earn interest long-term, can grow exponentially because interest earns interest. Unfortunately, many of us, try to time the markets in order to take advantages of dips in the market. The problem with that approach is that since even the experts cannot predict the future accurately all the time, if we try to do the same, it would be speculating vs. investing. The other issue is the emotional stress that one would have to endure if they got the timing wrong.
To drive the point home, let’s take a random eleven year period from Oct 2001 to Oct 2012 where you decide to invest in the Sensex. If you had missed out on the ten best days in the stock market in that period, a sum of Rs. 100,000 would have returned Rs. 2,50,270 as opposed to Rs. 5,33,180 had you stayed fully invested. In other words, for staying invested, the absolute return is 533% and for missing the best ten days, the absolute return is 250%. Missing the best ten days would have cost you a difference of 283%. Is there anyone out there in this world who could have predicted over a 10 year period when those 10 best days would occur?
In conclusion, focus on the 3 golden rules of successful investing:
- Invest for maximum real returns i.e. returns adjusted for inflation and taxes.
- Manage your risk vs. avoiding it.
- Spend time in the market vs. timing the market.
Everguard Life Ventures Pvt. Ltd.