Thumb rules to build wealth

‘Building wealth’ is a topic that’s searched by millions of people. Thumb rules to build wealth tries to summarize all the concepts that were discussed earlier, in a different format.

TWO STEPS

Basically, The entire process of building wealth boils down to just two steps:

  • The first step is to control your expenses according to your income and make a surplus out of it. It demands a lot of financial discipline to achieve this step. Many financial principles that would help you to save money were discussed in our first sessions.
  • The second step would be to find assets that have the potential to grown in value and invest your money in it.That’s it. :)

The first step is completely under your control and no one can help you out. You have to work hard, get a job , make a steady income and save some money for yourself. The earlier you start saving, the better it is.

Once you start earning, it’s natural for anyone to think about availing loans to realise their dreams –for example a big car. The bad news is that, more debts prevent you from saving more at the initial years. All successful investors have accumulated more money in their initial years. Early investing has many advantages as we have already explained in one of our previous posts.

Hence, the second step is to gain some basic financial knowledge. You are supposed to know some basic rules and concepts like inflation, compounding, opportunity cost, a bit of taxation and accounting. Learning the basic money magic will dramatically alter your view about finances and investing

The third step – investing, is the one where you will have to consider a lot of things. You’ll have to draw up a plan, list out your financial goals, assess your risk profile, seek the help of experts for valuation of different assets, assess the pros and cons of each type of asset and finally choose the best investment style and vehicle.

In this, drawing a plan and listing out your financial goals with some accuracy is the initial step. Clear cut and realistic financial goals have to be drawn. The most important factor that would help you to bring in realism into your plans would be your level of savings. You can’t draw up big plans if you expect to save only little.

Once you have drawn you plans, you can look for avenues to invest. Here, the best lesson you can get is from Warren Buffet, one of the richest stock investor.  He never invested in businesses which he couldn’t understand. His advice is simple “If you don’t know the business model, what the company does on a day to day basis, or how it generates revenue now, and in the future, then it’s better to stay away from it”. This principle can be applied to all types of investing. You have to make sure that you understand the basics. This advice assumes significance because; investors have a tendency to follow what the crowd is doing. If a particular stock is doing well at the bourses, investors jump in and put money without bothering to analyse what business the company is into. In short, you have to be through with the basics.

Diversification is the next area to be addressed. Diversification of money into different asset classes is required since you cannot predict the movement of asset prices and you cannot say which asset would perform best in a year. So, must have some money in all possible asset types. That’s what diversification is all about.

When you have a mix of assets in your kitty, what you have is a portfolio. Your portfolio will have to be periodically checked, reviewed and rebalanced since the value of assets with you will keep changing from time to time. For example- you have a portfolio in which 60% of the funds are in large caps and balance in mid caps. That year, if the equities go up by 30% and the mid caps fall by 2%, it will imbalance your portfolio and to make it back to that 60:40 levels, you will have to sell large caps that went up and buy mid caps that came down.

All the principles put together, you should be able to make a good return from your money. The thumb rules are:

Rule 1. Make money

Rule 2. Learn the basics of investments

Rule 3. Identify the assets to invest.

Rule 4. Diversify

Rule 5. Review your portfolio.

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Should you Borrow Money to Invest?

BORROWING TO BUY SHARES.

You know that stocks have returned an average of 17 to 18%. So you borrow some money at 9% interest and invest that amount in stocks. Until you realize the profit, you’ll pay interest or EMI from your pocket.Anyway you look at it, it’s going to be profitable. How about that? If you are planning to do something like that – you’re at the right time reading this article. Calculations on paper may show that it is practical. But in real life, such strategies are extremely risky. We advice not to leverage (that’s the financial term for using borrowed funds) your investments in any form. It’ not a good idea at all. There are three perils waiting for you when you leverage –

  • It multiplies your risk.
  • Even when the value of your holdings go down, you have to pay your loan installments. The effective cost you pay is very high.
  • There will not be any peace of mind. Guaranteed!

HOW DO INVESTORS LEVERAGE?

There are different ways:-

  • Take a personal loan or pledge you home or property or gold.
  • Borrowed funds from others like friends. The attraction here is that, it normally comes interest free.
  • Using borrowing facilities at the brokerage firm.
  • Short sell the stock. It is same as selling what you don’t have. Hence effectively, you are borrowing shares from someone and selling it.
  • Take the derivatives route ( futures and options)

The first two options need not be explained .It’s straight, simple and needless to say, totally dangerous. In the first case, If you could not pay back the money, your lose your home. In the second case, you’ll lose your friends and may also have a difficult time facing them. It might also put your friends in trouble. So stay away from such tactics.

The other three points need some explanation. Brokerage firms allow you to borrow money from their account based on the current total holding you have in your demat account maintained with them. What they do is very simple. They will take pledge of all your share holdings and give you a loan which would be a percentage calculated on the market value of the holdings. In case you couldn’t pay back the money to the broker, they will immediately sell off those shares in the market and realise the amount. At the time of signing the agreement itself, such clauses are already built into the agreement. The interest charged for this kind of temporary funds is also very high and it’s calculated on a day to day basis.

You can adopt this way of leverage when you do it for a very temporary purpose. For example – you were eyeing a particular stock and that stock is now at the price where you want to enter. You have money in your bank, but you’re travelling and not in a position to transfer it now. You can use money from your broker and pay it back in two days.

Another way to leverage is short selling. When you short sell a stock, you are selling stocks which you do not own. What you are effectively doing is, you borrow shares (instead of money) from the brokerage firm and when the price falls, will buy it gain and give it back to the broker. Short selling is a dangerous method to make money. What will you do if your calculations go wrong? You will have to pay more money and buy back the shares from the market and return it to your broker.

Through derivatives, you leverage in a different way. For a small sum (called margin money / premium) you can take big positions in the markets. It’s like playing a Rs 100,000 game with just Rs 10,000 in hand. The risk in such cases is very high. It has the potential to wipe off all your money. Derivatives are the favorites of speculators, although these instruments are basically meant for managing risk.

In short, if you ask us whether you should borrow funds, our suggestion is:

  • No, if you’re just a beginner or amateur.
  • No, if you don’t have any other sources of income to suddenly raise funds if calculations go out of control.
  • No, if you do not have an alternate plan to pay off these debts.
  • Yes, if you can get some funds totally interest free for a long period of time
  • Yes, if you are a very seasoned investor and you know with some certainty how the markets will move.
  • Yes, if you want to utilize a sudden surprise opportunity.
  • Yes, if you have fully understood the risk and the financial destruction it can bring, but still, you’re the daredevil type – ready to face anything.

BORROWING TO BUY OTHER ASSETS.

if you can get loan funds at a lower rate of interest (NRIs can get it , say at 4%) you can bring that funds to India and invest here in debt funds or NCDs that give as high as 13% per annum in return or they buy gold or just put it in fixed deposit with banks. Anyway , that’s not going to be a loss.

One factor that needs to be considered while buying assets with borrowed funds is that the loan to asset value should be preferably be kept at around 60%. That is, to buy an asset worth 10 lakhs, it good to borrow up to 6 lakhs and pay the balance in cash.

And remember, cars and electronic gadgets are not assets hence, relying on loans to buy such things Involves great loss.Such loans carry high rate of interest and these items depreciate heavily with time.

CONCLUSION.

Investing with borrowed funds is not recommended, except in very special circumstances. It is a very risky and aggressive strategy and should be used with a lot of caution.

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Investing or gambling?

“An investment is simply a gamble in which you’ve managed to tilt the odds in your favor.” – Peter lynch.

INVESTING OR GAMBLING ?

The first question before investing in any asset is – Have you learnt the basics?

Do you know the rules of valuation and decision making? Do you know the potential of that asset and the risk you’re taking? If you have committed money to something which you don’t know, realise that you are gambling. When you do a lot of research and put your money in assets that would make you rich after a long time, you’re investing. Investing is a good thing to do.  That’s a positive step. The odds to win are in your favor. On the other hand, when you gamble, you’re putting your money in something which is considered to be a ‘hot asset’. It may give you gains. But, the risk you take is very high. In most cases, such assets would be in an overvalued state and you might end up buying at higher rates. In short, odds-to-win are not in your favor.

Some other positive aspects of investing are that

  • It’s done with specific goals in mind –for e.g.-buying a home.
  • It’s a continuous effort. You put in your money not once but several times after a lot of study and effort and wait for thing to be favorable to you.
  • It’s a long process and results are achieved after a lot of hard work and analysis. It’s not by luck.
  • Investors achieve their targets by taking risks, positively.  They take risks in a very calculated way.

As opposed to all this, gambling or speculation is not done with specific long term objectives.  Money is put into any asset recklessly without analysis. They rely on luck and if they win they get what they desire-an instant gratification. This negative aspect of gambling can sometimes become addictive too.  This is not to say that investing is not addictive. Surely it is. Warren buffet and our own Rakesh jhunjhunwala are definitely investment addicts. Getting addicted to something positive is a good thing. It has no side effects! But, gambling is definitely a problem to be rectified. It has many side effects. People lose millions, wealth of families has been wiped out, and many have ended their lives due to loss from gambling.  I know many stock market players who jump into F& Os even without knowing what they really are or the dangers it can bring.

A lot of so-called investors do not research meticulously and buy on tips or rumors, or based on some analyst’s price target. These guys can also be included in gamblers list. Similarly, investors who make investment decisions purely on the basis of emotions rather than being professional and  sticking with their strategy, are to some extent gambling.

ENTERTAINMENT OR SERIOUS BUSINESS?

Internet has revolutionized the way we buy and sell stocks in the market. With internet, trading is done at the comfort of your home. However, such advancement has also made some section of people addicted to online trading as a form of entertainment. They just have fun playing in the market. While making friends from investing circle, make sure that your friends are serious investors! Or else, it’s not god for your investing future. Hope you’re clear!

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What is Financial planning?

FINANCIAL PLANNING

Financial planning is a broad term and investing is just a chapter in it. Financial planning is all about listing down all you sources of finance, assessing your financial needs for the future, assessing your appetite for risk and then charting a plan to achieve your dreams. It also involves planning for your child’s future , your new home, planning for tax and retirement. So, it’s a very broad term and you might need an expert to draw it for you.

FINANCIAL GOALS-LONG TERM VS SHORT TERM

When you chart your financial goals for the future, it important to classify them into short term goals and long term goals.  A short term goal is anything that needs to be done in , say , 5 years. For example – buying a 3 BHK flat. Any financial goal like your son’s higher studies or your daughter’s wedding which has ample time left to think and plan, can be said to be a long term goal

WHAT’S THIS  FUSS ABOUT? WE ARE AWARE OF ALL THIS.

..But still, the importance of financial planning needs to be emphasized in today’s world. Today, the work pressure is so high that people want to opt for early retirement from their full time jobs, preferably in their mid 40’s or early 50’s. They have realized the importance of living their life to the fullest. Thanks to advancement in medial sciences, the average life expectancy has increased to 70 or 80 which means that a person who has retired at 50 has another 30 years to live, without depending anyone  (Preferably!).

Financially, this means  that during you working life, you should create wealth enough to help you maintain the same standard of living after you retire and also take care of your medical expense which keeps going high as you get older. Planning for all this is definitely a difficult and disciplined task. Such a target  is not easy to achieve and it requires meticulous planning and disciplined carry through. That’s why financial planning is so important.

DO I NEED A FINANCIAL PLANNER?

May be or may be not. That depends on who you are. A financial planner is a person who is an expert in his field. It’s better if you can consult a financial planner because even though it’s possible that you are well versed in finance; you’re still not a financial planner. A planner will be able to analyse of your current financial situation quickly and suggest   recommendations that are right for you. There are also personal finance magazines and self-help books to help you do your own financial planning. At the end of the day – the right amount of money should be at your disposal at the right time.

Seek the services of a financial planner if:

  • You find it difficult to analyse your risk profile. Most of us are not fully aware of where we stand in terms of risk.
  • You don’t have time to do your own financial planning.
  • You want to take a professional opinion about the financial plan you have done.
  • You think that you should improve your current financial situation but still don’t know where to begin and how to implement those changes.

FINANCIAL PLANNING ISN’T JUST FOR THE RICH

All right, anyway I don’t have much money to invest. What’s there to plan? If you’re thinking on these lines, you’re wrong. People with limited income should definitely plan you finances – at some point of time you need to get married, buy a home, raise children and look after your ageing parents. The rich will always manage all this even if they haven’t planned their finances properly. But if you’re from a middle class background, you just cannot ignore financial panning.

Basic financial planning is not so complicated. If you have loans first pay them off at the earliest. Loans will anyway carry a higher rate of interest. Be debt free. That definitely is the first step. Then , think about how much you can save. Start a recurring deposit. Accumulate small amounts fro your monthly income even if you have to live on a shoe string budget. Two years down the lane, you’ll find that you’ve done a good job accumulating some money. Once you have some cash, start a systematic investment plan. Take insurance policies. Buy gold when ever you can, even if it is a tiny piece. You’ll be on your way …

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