Module 1   Introduction to Stock MarketsChapter 1

The Need to Invest

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Ch 1 Need to Invest

Investing money is necessary to survive the increasing cost of living.

 

1.1 Why should one Invest?

Before we address the above question, let us understand what would happen if one chooses not to invest. Let us assume you earn Rs.50,000/- per month and you spend Rs.30,000/-towards your cost of living which includes housing, food, transport, shopping, medical, etc. The balance of Rs.20,000/- is your monthly surplus. For the sake of simplicity, let us just ignore the effect of personal income tax in this discussion.

To drive the point across, let us make a few simple assumptions.

  1. The employer is kind enough to give you a 10% salary hike every year
  2. The cost of living is likely to go up by 8% year on year
  3. You are 30 years old and plan to retire at 50. This leaves you with 20 more years to earn
  4. You don’t intend to work after you retire
  5. Your expenses are fixed and don’t foresee any other expense
  6.  The balance cash of Rs.20,000/- per month is retained in the form of hard cash

Going by these assumptions, here is how the cash balance will look like in 20 years.

Years Yearly Income Yearly Expense Cash Retained
1 600,000 360,000 240,000
2 6,60,000 3,88,800 2,71,200
3 7,26,000 4,19,904 3,06,096
4 7,98,600 4,53,496 3,45,104
5 8,78,460 4,89,776 3,88,684
6 9,66,306 5,28,958 4,37,348
7 10,62,937 5,71,275 4,91,662
8 11,69,230 6,16,977 5,52,254
9 12,86,153 6,66,335 6,19,818
10 14,14,769 7,19,642 6,95,127
11 15,56,245 7,77,213 7,79,032
12 17,11,870 8,39,390 8,72,480
13 18,83,057 9,06,541 9,76,516
14 20,71,363 9,79,065 10,92,298
15 22,78,499 10,57,390 12,21,109
16 25,06,349 11,41,981 13,64,368
17 27,56,984 12,33,339 15,23,644
18 30,32,682 13,32,006 17,00,676
19 33,35,950 14,38,567 18,97,383
20 36,69,545 15,53,652 21,15,893
Total Income 17,890,693

If one were to analyze these numbers, you would soon realize this is a scary situation to be in. Few things are quite startling from the above calculations:

  1. After 20 years of hard work you have accumulated Rs.1.7Crs.
  2. Since your expenses are fixed, your lifestyle has not changed over the years, you probably even suppressed your lifelong aspirations – better home, a better car, vacations, etc
  3. After you retire, assuming the expenses will continue to grow at 8%, Rs.1.7Crs is good enough to sail you through roughly about 8 years of post-retirement life. 8th year onwards you will be in a very tight spot with literally no savings left to back you up.

What would you do after you run out of all the money in 8 years’ time? How do you fund your life? Is there a way to ensure that you collect a larger sum at the end of 20 years?

Let’s consider another scenario where instead of keeping the cash idle, you choose to invest the cash in an investment option that grows at let’s say 12% per annum. For example – in the first year you retained Rs.240,000/- which when invested at 12% per annum for 20 years yields Rs.2,067,063/- at the end of 20th year.

Years Yearly Income Yearly Expense Cash Retained Retained Cash Invested @12%
1 600,000 360,000 240,000  20,67,063
2 6,60,000 3,88,800 2,71,200  20,85,519
3 7,26,000 4,19,904 3,06,096  21,01,668
4 7,98,600 4,53,496 3,45,104  21,15,621
5 8,78,460 4,89,776 3,88,684  21,27,487
6 9,66,306 5,28,958 4,37,348  21,37,368
7 10,62,937 5,71,275 4,91,662  21,45,363
8 11,69,230 6,16,977 5,52,254  21,51,566
9 12,86,153 6,66,335 6,19,818  21,56,069
10 14,14,769 7,19,642 6,95,127  21,58,959
11 15,56,245 7,77,213 7,79,032  21,60,318
12 17,11,870 8,39,390 8,72,480  21,60,228
13 18,83,057 9,06,541 9,76,516  21,58,765
14 20,71,363 9,79,065 10,92,298  21,56,003
15 22,78,499 10,57,390 12,21,109  21,52,012
16 25,06,349 11,41,981 13,64,368  21,46,859
17 27,56,984 12,33,339 15,23,644  21,40,611
18 30,32,682 13,32,006 17,00,676  21,33,328
19 33,35,950 14,38,567 18,97,383  21,25,069
20 36,69,545 15,53,652 21,15,893  21,15,893
Total cash after 20 years  4,26,95,771

With the decision to invest the surplus cash, your cash balance has increased significantly. The cash balance has grown to Rs.4.26Crs from Rs.1.7Crs. This is a staggering 2.4x times the regular amount. This translates to you being in a much better situation to deal with your post retirement life.
Now, going back to the initial question of why invest? There are a few compelling reasons for one to invest.

  1. Fight Inflation – By investing one can deal better with the inevitable – growing cost of living – generally referred to as Inflation
  2. Create Wealth – By investing one can aim to have a better corpus by the end of the defined time period. In the above example, the time period was up to retirement but it can be anything – children’s education, marriage, house purchase, retirement holidays, etc
  3. To meet life’s financial aspiration

1.2 Where to invest?

Having figured out the reasons to invest, the next obvious question would be – Where would one invest, and what are the returns one could expect by investing.

When it comes to investing one has to choose an asset class that suits the individual’s risk and return temperament.

An asset class is a category of investment with particular risk and return characteristics. The following are some of the popular asset classes.

  1. Fixed income instruments
  2. Equity
  3. Real estate
  4. Commodities (precious metals)

fixed-inst-icon Fixed Income Instruments

These are investable instruments with very limited risk to the principle and the return is paid as an interest to the investor based on the particular fixed-income instrument. The interest paid, could be quarterly, semi-annual or annual intervals. At the end of the term of deposit, (also known as maturity period) the capital is returned to the investor.

Typical fixed income investment includes:

  1. Fixed deposits offered by banks
  2. Bonds issued by the Government of India
  3. Bonds issued by Government related agencies such as HUDCO, NHAI, etc
  4. Bonds issued by corporate’s

As of June 2014, the typical return from a fixed income instrument varies between 8% and 11%.

 equity-icon1Equity

Investment in Equities involves buying shares of publicly listed companies. The shares are traded both on the Bombay Stock Exchange (BSE), and the National Stock Exchange (NSE).

When an investor invests in equity, unlike a fixed income instrument there is no capital guarantee. However, as a trade-off, the returns from equity investment can be extremely attractive. Indian Equities have generated returns close to 14% – 15% CAGR (compound annual growth rate) over the past 15 years.

Investing in some of the best and well run Indian companies has yielded over 20% CAGR in the long-term. Identifying such investment opportunities requires skill, hard work, and patience.

Taxation on Equity investments held for more than 365 days is taxed at 10%, if the gains are more than Rs 1 lakh starting from 1st April 2018(previously such investments were tax-free). This is comparatively a lower rate of tax than the other asset classes

real-estate-icon

Real Estate

Real Estate Investment involves transacting (buying and selling) commercial and non-commercial land. Typical examples would include transacting in sites, apartments and commercial buildings. There are two sources of income from real estate investments namely – Rental income, and Capital appreciation of the investment amount.

The transaction procedure can be quite complex involving legal verification of documents. The cash outlay in real estate investment is usually quite large. There is no official metric to measure the returns generated by real estate, hence it would be hard to comment on this.

commodity-icon

Commodity – Bullion

Investments in gold and silver are considered one of the most popular investment avenues. Gold and silver over a long-term period have appreciated in value. Investments in these metals have yielded a CAGR return of approximately 8% over the last 20 years. There are several ways to invest in gold and silver. One can choose to invest in the form of jewelry or Exchange Traded Funds (ETF).

Going back to our initial example of investing the surplus cash it would be interesting to see how much one would have saved by the end of 20 years considering he has the option of investing in any one – fixed income, equity or bullion.

  1. By investing in fixed income at an average rate of 9% per annum, the corpus would have grown to Rs.3.3Crs
  2. Investing in equities at an average rate of 15% per annum, the corpus would have grown to Rs.5.4Crs
  3. Investing in bullion at an average rate of 8% per annum, the corpus would have grown to Rs.3.09Crs

Clearly, equities tend to give you the best returns especially when you have a multi-year investment perspective.

A note on investments
Investments optimally should have a strong mix of all asset classes. It is smart to diversify your investment among the various asset classes. The technique of allocating money across assets classes is termed as ‘Asset Allocation’.

For instance, a young professional may be able to take a higher amount of risk given his age and years of investment available to him. Typically investors should allocate around 70% of their investable amount in Equity, 20% in Precious metals, and the rest in Fixed income investments.

Alongside the same rationale, a retired person could invest 80 percent of his saving in fixed income, 10 percent in equity markets and 10 percent in precious metals. The ratio in which one allocates investments across asset classes is dependent on the risk appetite of the investor.

1.3 What are the things to know before investing

Investing is a great option, but before you venture into investments it is good to be aware of the following…

  1. Risk and Return go hand in hand. Higher the risk, higher the return. Lower the risk, lower is the return.
  2. Investment in fixed income is a good option if you want to protect your principal amount. It is relatively less risky. However, you have the risk of losing money when you adjust the return for inflation. Example – A fixed deposit which gives you 9% when the inflation is 10% means you are losing a net 1% per annum. Fixed-income investment is best suited for ultra risk-averse investors
  3. Investment in Equities is a great option. It is known to beat inflation over a long period of time. Historically equity investment has generated returns close to 14-15%. However, equity investments can be risky
  4. Real Estate investment requires a large outlay of cash and cannot be done with smaller amounts. Liquidity is another issue with real estate investment – you cannot buy or sell whenever you want. You always have to wait for the right time and the right buyer or seller to transact with you.
  5. Gold and silver are known to be a relatively safer but the historical return on such investment has not been very encouraging.

 


Key takeaways from this chapter

  1. Invest to secure your future
  2. The corpus that you intend to build at the end of the defined period is sensitive to the rate of return the investment generates. A small variation to rate can have a big impact on the corpus
  3. Choose an instrument that best suits your risk and return appetite
  4. Equity should be a part of your investment if you want to beat the inflation in the long run

710 comments

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  1. Pedro says:

    wrong commas throughout the table like
    xx, xx, xxx

  2. lian says:

    Sorry, but I didn’t understand why, in the second table, at the Retained Cash Invested @12% column, the values start decreasing after the 12th year. Look at the image:

    • Karthik Rangappa says:

      Lian, that is because even though the guy has a higher amount to invest, he is investing for a shorter duration. Hence lesser time for the money to compound and grow.

      • Kaushal Singh says:

        still why do we consider compound interest rate @ 12% ?
        Is it ideal? or do we have any graphical value? or do we have any calculation method?

        • Karthik Rangappa says:

          That is roughly the long term average CAGR of the top 20 – 25 mutual funds in India. You can find plenty of research on this online.

  3. Chandra Sekhar says:

    This site is unique and useful for investors.
    I am an investor. I am in Canada and I invest in NYSE and in TSX Mkts.
    As I have business interest in India, would be looking for opportunities there.
    You may keep me in your mailing list

  4. RP1256 says:

    This would be really helpful for all who want to understand and invest. 🙂

  5. R K verma says:

    What is the good ratio to invest in the age of 25. How much in equity and how in other instruments.

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