Deepak is a former colleague of mine. He follows my blog (started recently) and my investments. When we met last Sunday he said his portfolio just delivered 9% in last 4 years while mine had done a decent 27% p.a. He said his portfolio mostly mirrored mine and wanted to know why this difference in performance.
When I looked into his portfolio, I could see why. Then I decided to write on “How to choose savings and investments for your need?”.
While going through his portfolio I found that his portfolio did not resemble mine. He had most of my stocks. But most were bought at different time and at different prices. The proportion of stocks also differed.
For example, if I had 75 Page Industries shares at average price Rs.635, he had 40 shares of Page Industries at average of Rs.4800. While I sold out few stocks I held 4 years ago, he still had some of them. And the story goes on with different stocks. I’m saying this for below reasons
- Do not go by some one’s recommendation/actions. Do your own analysis and choose your stock investments. When a person gives you advice to buy, he may not be around to give the sell advice. That is reason I don’t give stock advice to individuals except old clients.If there is any such stock, I will blog about it in future. In this case, I bought a few stocks 3 years ago and Deepak was sitting next to me when I made the purchase and at the time I said it seemed like promising investment. I later moved to a different office work location and sold the stocks held due to changing fundamentals. I didn’t know he was holding them until we met now.
- Each person financial needs/goals are different – If everyone had same goals and needs, then you can copy other’s portfolio. Then there is no need for financial advisors. Everyone would be identical. But that is not the case. My responsibilities, goals, time frame, risk taking abilities is completely different from yours. That is why each one has to have their own financial plan.
Managing your savings and investments to give you the best and most appropriate return, is often the most important factor or aspect of financial planning. So know we are going to see the perfect steps one must take to choose savings and investments.
How to choose savings and investment products
So what are the main factors that determine your investment or are likely to influence which broad types of investments are suitable for you?
FACTOR #1) YOUR GOALS – Remember I said YOUR goals not just goals. You may have many reasons for saving or investing but essentially everything boils down to three main objectives.
- Number one is growth. Growth is nothing but increasing the amount of capital you have.
- Number two is present income, generating income now to supplement your income or salary etc.
- Number three is future income, generating an income that will start at a later date for example when you retire and your earnings stop completely.
Different products are usually suitable for each of these goals. Sometimes the same product used in a different way can help you meet different goals.
Often objectives are interrelated for example, if you need extra income starting now, in order to ensure that you maintain a comparable income in future, you usually need to invest at least some of your money for growth.
FACTOR # 2) YOUR INDIVIDUAL RISK CAPACITY -The next factor is your attitude towards risk; when you think of investment risk you probably think of losing part of your original investment, this is called as capital risk.
But these are not the only type of risks for example in addition to capital risk we also have something called inflation risk, shortfall or the interest rate risk. You have to strike a balance between all of them, in particular over long term there’s a very strong relationship between capital risk and return. This can be achieved by proper asset allocation.
Investments by value of capital cannot fall such as bank fixed deposits over a period of five to ten years give lower returns than investments such as stock market. Understandably many retired people are cautious with their savings and investment and reluctant to take capital risks.
Because once your earnings have stopped it may be very hard or impossible to make good any loses made on your investments.However if all are sticking to bonds, fixed deposits and fixed instruments it will reduce capital risk, but it increases the shortfall risk and the inflation risk.
Acting in a way that minimizes capital risks but ignores other risks is sometimes what you can call as extreme caution. If you are saving or investing only for a short or medium term it is usually not appropriate to take capital risk.
To manage capital risk you need ability to ride out short term dips in the value of your investments. It becomes impossible if you need your money again at short notice or at a specific time.
Different types of Risks
So what are the different types of savings and investment risks?
- Capital risk. -This is nothing but the amount of your original investment falls. For example because the price of investment falls you have to pay large surrender charges or the provided funds to repay the investment as promised.
- Inflation risk. – This is where the buying power of your income or capital falls because it does not grow fast enough to keep up with inflation. When your inflation is 8% and you get just 4% per annum from your investments over 20 years then there is no use in that investment.
- Shortfall risk. – This is where you cannot meet your goal because the return on the investment is too low. Assume, you want to pay for your daughters marriage or your son’s education. You have a predetermined target amount and for 10 years your investments return lesser than what you planned for. You will not be having enough money for your daughter’s marriage or your son’s education.
- Interest rate risk. – So if you choose a variable interest rate the risk is that the interest rate may fall. If you choose a fixed rate of interest the risk is that the competing interest rate rise leaving locked into lower returns.
So these are the type of risks which are involved when you are saving or investing. Analyze the risks before making your decisions.
FACTOR# 3) TIME FRAME – So the third factor which determines how to choose saving and investment products, is how long you can invest. The length of time over which you save or invest will determine how much capital risk you can take and will thus influence the size of investment.
How long you can invest influences your choice in other ways also, for example some saving products offer a higher return if you can invest for say, five years.
Some investments such as some insurance policies have hefty surrender charges that means you have to commit yourself to long-term saving in order to get a reasonable return.
Other investment vehicles like PPF restrict access to your money before a certain time, or until a certain number of years have passed. So these are totally unsuitable if you need your money back in a few years from now.
FACTOR #4) – SIZE OF INVESTMENT – The fourth factor which determines what type of savings or investments is suitable for you is how much you can save or invest.
There are many products that have a minimum investments or savings limit which put a barrier. Some others have high charges that make investing or saving small sums nonviable. If you are investing only small amounts then you should avoid taking large risks with your money.
FACTOR #5) – TAX STATUS – The fifth factor is going to be tax position. Each saving and investment instrument is taxed in a different way this can have a big impact on the after tax return that you get.
Depending upon your income tax or your capital gains tax position some investments will give you more tax efficient returns than others.
Here are a few general guidelines that you can follow. If you are a non-taxpayer then avoid investments that tax has already been paid and cannot be reclaimed for example, shares and most life insurance products. If you are taxpayer in the lower bracket ie., 10% and have savings related income, make sure to select investments with tax deductions.
If you taxpayer try to make use of the unknown allowances that are listed that let you have taxpayer returns. If you pay income tax but no capital gain tax considered investments that produce gains rather than income.
FACTOR #6) HEALTH CONDITION -So the sixth factor that determines how to choose your savings and investment instruments is your health. For example if you are going to invest in insurance, or annuities then your health plays a vital part in determining how much you should invest or set to allocate for these types of investments.
For example in stock market if your health is poor and you are considering an investment that locks you in, or is designed to run for a longer period, think what would happen if you had to die during that period.
FACTOR # 7) YOUR TIME COMMITMENT – You need to choose savings and investments also based on how much time you can devote. If you are very busy and don’t have time to track investments, do not get into direct equity.
If you cannot spens time to analyze, track and think about your investments, you will make hasty decisions. This will lead to buying the wrong stocks or products. Instead you should choose good mutual funds and stay the course.
So these are the preliminary factors or the major factors which decide what type of savings or investment suit for a particular person.
You should plan accordingly and make decisions on the type of savings and investments you want to make it is ultimately your money and it is your decision and you have to live with your decision