Here’s taking a look at a few steps which will set you off on the path of financial security. The days when you could take uninformed decisions, not worry about your investments or expenses, put your feet up and watch the world go by are over forever. Constant monitoring, constant analysis of risks and returns and the need to match them to your risk appetite, dumping old products for new and better ones – is the name of the game now. Here is a five-step guide to wealth creation.
Invest before you spend
It is always easy to spend. Before you know it, all the money is gone. The end of the month sees you craving for the next pay. Very often, a portion of the next pay is also spent before you actually see it. Saving for the future? You will say, “Forget it, I need the money today”. To avoid this situation, the easiest way to inculcate a discipline to save, is to invest about 10 per cent of your take-home salary right at the beginning of the month. You can then spend the balance 90 per cent without any feeling of guilt.
Understand your risk personality
Before undertaking any investment, it is imperative for you to know what your risk appetite is. There are two elements that define your risk personality. The first is ‘risk capacity’ which is about external factors such as the number of dependents, your age, etc.Usually, most of these elements are not in your hands. You can do little about them. The second is ‘risk tolerance’. This consists of internal and mostly controllable elements such as attitude towards investment decisions, ability to cope with losses etc. After listing out specific elements of your risk personality, you would know how much risk you can take. You might be able to take greater risks in exchange for higher returns or you might want to take little risk in exchange for low, but reasonably assured, returns. All this should help you decide if you are an aggressive, very aggressive, balanced or conservative investor.
Your risk personality
Caution: Don’t go by conventional ideas. They might mislead you. For example, according to accepted wisdom, a 30-year old person is supposed to be more aggressive compared to a 40-year old person. But if the 30-year old person has dependents, no accumulated wealth and is in an unsteady job, he should be more conservative in investing compared to a 40-year old person who has no dependents but has wealth and is in a rock-steady job. Your risk profile should take into account your unique situation.
Assess your financial needs
Now that you have figured out your risk personality, you need to know what you want out of your investments. Do you want to save for a vacation next summer? Or is it for retirement? Perhaps you want to set aside some amount for your daughter’s college admission that is coming up in the next five years. Each one of these needs calls for a different strategy to follow, even for persons who share similar risk profiles. The most important aspect that needs to be kept in mind is that prices will rise with time due to inflation. For instance, if your daughter is 10 years old today, her marriage at about 21 years of age, is 11 years away. If her marriage would cost you Rs 25 lakh today, it will cost you much more when she is ready for marriage. This is because of inflation. Taking a 5 per cent annual increase in inflation, the Rs 25 lakh cost today will rise to about Rs 42.5 lakh after 11 years. Broadly, check if you need the money for recurring expenses or for a one-time event like buying a house, child’s marriage, etc. Recurring expenses can be usually taken care of by generating returns from safe investments like RBI Relief bonds, debt oriented mutual funds and so on. Event-based expenses can be tackled by investing in equity for a long term and converting the investment into safer debt choices closer to the event.
Diversify to reduce risk
Risk management is the cornerstone of any financial planning effort. One of the basic principles of portfolio building is diversification. As the old saying goes, "Don’t put all your eggs in one basket." This is imperative since no two investments behave exactly the same way. Investing in only one type of investment will make your portfolio lopsided and lead to higher risk. A mix of investments is the best way to bring down the portfolio risk.
We live in an era of dynamic investments. Risk and return profiles of investments are changing by the day. Couple of years ago, if you had been told that PPF was going to fetch a 8 per cent return you would have laughed at the statement. But that is exactly what has happened now. Investments have been changing since economies are in a flux and business cycles are shortening. Rock-solid investments may look wobbly a few years down the line. You have no choice but to monitor if possible on a quarterly basis, whether your investments are in line with your expectations, risk profile and needs.
The key is to undertake all the above-mentioned steps together and not in isolation. Doing so will enable you to create wealth, achieve financial security and attain freedom.