Investment Basics

Investment – What, Why to invest, When to invest, Principles/Elements of investment, How to plan investment?

1.1 What is Investment?

We all are aware of the rising cost of living i.e., the prices of all goods and service keeps increasing.  But we could also see that along with rise in prices, quality of life of some is improving and they are not worried about the price increase.  And of course, many are struggling to cope with the increasing cost.  You may wonder, why some are able to lead a better financial life while others could not.

Let us understand the answer to this question from a story of a wealthy man and a poor man.

Wealthy Man and Poor Man

In a town there lived a wealthy man who was unwise and lazy. He had acquired all his wealth from his forefathers and was living a lavish life with the inherited wealth.

An old man who was his father's friend and his well wisher was very worried about the wealthy man's irresponsible living style. And he used to condemn him and advise him to use the inherited wealth in a productive way.

But the wealthy man was haughty and ignored his advise saying he has lots of wealth which can take care of his many generations down the line and the necessity to save or invest does not arise.

In the same town there was a poor man who is wise and hard working. He worked hard to earn his living and saved a fraction of his earnings for his old age expenses.

Suddenly, there was drought and prices of food grains doubled. So, he had to pull out more money to buy food and he had to use his savings for the purchase.

Gradually he started realizing that whatever he is saving now will not be enough to take care of his old age requirements. So, he was thinking of ways to make his hard earned money to grow.

So, he traveled to the neighborhood and bought few hens out of his saved money.  The hen laid eggs and he started earning by selling the eggs apart from his regular work.

Then he saved the money earned by selling eggs and bought goats. He sold goat milk and earned even more money. So, now his source of income has increased to three. And he also owns hen and goat. His investments yielded returns and he continued to invest further and further and was growing exponentially.

After a decade, the wise poor man, has grown to be a quiet wealthy man and the once wealthy man who was unwise lost all his inherited wealth and has become poor.

Later, people in the city quoted both these men as good and bad example to teach their children how to use money wisely.

From this story of a wealthy man and a poor man, can you infer the difference between savings and investment?  When the poor man was just saving or keeping aside some money for future, he did not grow financially, whereas when he started to invest the saved money in a productive asset or a business, his assets and sources of income grew.  Further, from the example of wealthy man, we could draw the moral that irrespective of the current financial position, investment is important to keep growing financially.  Otherwise how much the inherited wealth be, it will melt down if it is kept idle.

1.2 Why to Invest?

Having understood the difference between savings and investment, we may need more reason to convince our self why it is necessary to invest rather than just save.  To understand this we need to know how the value of money changes over a period of time.   In financial term the change in worth of money is known as “Time Value of Money”.

1.2.1 Time value of money

To understand the time value of money let us see the worth of Rs.100/- 20 years back and its worth now.

With Rs.100 it was possible to get 5 kgs of rice 20 years back when the cost of 1 kg of rice was Rs.20/-.  But now with that same Rs.100 we could  get only 2 kg of rice as the price of 1 kg of rice is Rs.50 now.

So, the power of Rs.100 to buy goods or service has decreased.

This is "Time Value of Money".

Rs.100 was worth more 20 years back than it is now.

In another 10 years, the value of Rs.100 will decrease further and you may be able to buy only 1 kg of rice or it may not be enough to buy even 1 kg of rice.

From this example we could understand that the purchasing power of money decreases over a period of time.  But why it decreases?  It is due to inflation and opportunity cost.  Inflation and opportunity cost are all financial jargon used by experts.  But it is all very simple things that we come across in daily life.

1.2.2 Inflation and causes of inflation

Put it simply, inflation is “sustained increase in price of goods and services”.  What causes the increase in price of goods and services?  Three factors may cause the increase -

  • Increase in demand and decrease in supply of goods and service
  • Increase in cost of production of goods
  • Increase in money supply in the hands of the public

To understand inflation and the causes of inflation, let us take a look at what Tom and Jerry are doing to get their most favorite ice cream.

Tom and Jerry

Tom's grandpa used to give him Rs.50 every time he comes to visit him. And Tom immediately rushes to near by ice cream parlor to get his favorite ice cream with this money. One sunny day, his grandpa on his visit gave him only Rs.25. Tom became sad because his favorite ice cream cost Rs.40/-. He somehow adamantly managed to get Rs.50/- as usual from his grandpa and ran fast to get the ice cream.

But to his disappointment the price of ice cream has increased by Rs.20/- as there was some short supply of ice creams and there were rush in the shop to buy the ice cream. Then Tom saw his friend Jerry who had also come to buy the ice cream. Both were waiting in the queue. The shop keeper, on seeing the crowd (demand) to buy the ice cream, increased the price of it by another 10 rupees.

Tom asked his friend Jerry to lend him the extra needed money, but Jerry refused to lend him money because he wanted to buy more ice cream for his sister and his small brother. Jerry said “sorry Tom my dad got promotion in his job with higher salary and he wanted to get us our favorite ice cream. And I cannot lend you at this moment, I will definitely help you next time. Despite of increased price, Jerry and others wanted to buy the ice cream as they could afford to buy it at higher price.

So, the disappointed Tom said to himself ”ok. Let me buy chocolate this time” and headed towards chocolate shop. To his surprise, the price of his favorite chocolate also had increased. The disheartened Tom returned home with some small chocolate.

When Tom's father saw him returning home sad, asked him “Tom, what happened, Why are you so dull?” Tom replied in an undertone “dad, cost of ice cream and chocolates have gone up and I could not afford to get one for me”. And added “dad you know even at high price Jerry and others were ready to buy it and the bad shop keeper kept increasing the price. I could get only this small chocolate with the money I had”. On hearing this Tom's father gently hugged him and said “This is the reason why I used to tell you to save some money out of what your grandpa gives you. See, if you had saved the money, now you could have bought your favorite ice cream even when the price had gone up”. You are always right dad! Tom replied & stepped out to garden to play.

From the story of Tom & Jerry, we could understand that inflation or price rise of goods and services leads to the decrease in purchasing power of money.  When there was a price increase i.e. inflation, the money he had, could not buy him the ice cream.  So, the power of money to purchase ice cream decreased.  But what led to the rise in price of ice cream?  First, the demand for ice cream was high but at the same time supply of ice cream was also low.  Moreover, Jerry and others were having more money and were willing to buy even at high price.  So, money supply was more.  This is another reason for inflation or price increase.

1.2.3. Opportunity Cost

Now we will see about another cause that brings down the purchasing power of money.  That is “opportunity cost”.  This is nothing but “the choice between two options.  It is “the opportunity we give up for choosing another”.

Let us understand this with an illustration.

Mr.Gautham a medical practitioner has two options – one is to practice medicine in his hometown where his parents are living. Another is to go abroad where there is large scope to practice medicine. Now he has to choose between the two options.
He is in a mess and could not arrive at a decision because both the options has its own merits and demerits.
If he chooses to stay in his home town he can very well practice medicine and also take care of his parents.
Whereas, if he chooses to go abroad, he has good scope to earn more, but he has to leave his parents alone here as they are not willing to go with him to abroad.
Finally, Gautham decides to choose to be with his elderly parents and practice medicine in his hometown.

In this illustration, Gautham loses the opportunity to earn more abroad and instead chooses the option to stay with his parents in India and this is the opportunity cost he pays.

One more aspect of opportunity cost is the interest income that the money could earn and existence of future risk.  To understand this imagine what would be your reaction if you are given a choice to collect Rs.100,000 now or 2 years later, what will you choose?  Would you not prefer to collect the money now instead of 2 years later? Why do you want to get the money now?  Probably, you may think there may arise default risk on the part of the person who will pay you after 2 years or you may think you can earn interest on that money if you park it in a bank deposit instead of leaving it idle with another person.  In deed, this is the OPPORTUNITY COST.

To sum up, opportunity cost means – the opportunity we give up for choosing another, opportunity to earn interest, existence of future risk.

1.3 When to invest?

After knowing about the inflation and causes of inflation, opportunity cost and so on, we are convinced that investment is very important in everyone's life. But when to start investing? We often hear investment gurus advising to start investing at the early stage of our life. Why do they say so? In what way it is better to start early? Let us see an example of three persons of same age who wants to achieve targeted corpus of Rs.2.20 crores after 30 years. To achieve this goal, Anubhav starts to invest at the age of 25, Gaurav starts to invest 10 years later at the age of 35 to achieve his target of Rs.2.20 crores and Vaibhav starts at the age of 45. Anubhav who started at the age of 25 shells out Rs.100,000/- per annum, while Gaurav shells out Rs.310,000/- per annum and Vaibhav shells out Rs.11,90,000/- per annum to achieve the same goal of Rs.2.20 crores at the age of 55.

CLICK HERE to view the calculation of estimated returns on investments

We could see that if started early, the amount of money to invest per annum to achieve the targeted corpus in future will be less, whereas, to achieve the same target, the one who starts 10 years or 20 years later will have to part with more money as investment.  The below chart depicts it clearly.

In this chart, we could see that the amount of money invested by Anubhav who started early is Rs.1 lakh whereas, Gaurav who started 10 years later had to invest 210% more money per annum to achieve the targeted amount. And Vaibhav who started to invest 20 years later had to invest whopping 1090% more money to achieve the same targeted money. In this example, 20 years later means Vaibhav will be starting to invest at the age of 45, the age at which it will be very difficult or stressful to part with such a huge money, especially if the person had to confront with health issues.

Through this example, we could clearly understand the benefit of starting to invest at early age and the implications of failing to invest at young age.

1.4.Principles/ Elements of Investment

Having understood the importance of investing, we have now arrived at a decision to invest our hard earned money.  And we are geared up to start early.  But before stepping into investment, we need to understand the factors involved in investments.  We need to set out our priorities for which we need to know the elements or features of investment.

Investment involves three important elements.  All three elements are inter-related.  They are:

  • Risk
  • Reward
  • Time

Risk

We will accept the fact that in this world nothing is risk-free.  Life is inherently risky.  Even when we are sitting leisurely and watching TV, there is some element of risk involved.  In investment, there is risk of incurring loss, losing our capital or risk of getting lower returns against expected returns.  The risk may arise due to multiple factors.  It may be due to default on part of the issuer of some form of securities, economic changes, global factors and it may be also due to negligence on our part or due to psychological factors.  However, the risk involved in investment is manageable.  So do not be disheartened.  We will discuss on how to manage the risk with risk management tools in detail in a separate chapter.

Where there is a risk there is a reward

We would have all heard about risk and reward.  The more we risk, the more we will be rewarded.    Risk and reward goes hand in hand.  But are we willing to risk when it comes to finance?  In fact, we SHOULD TAKE RISK in investing if not for any other purpose.

Few years back I came across a person who was dare enough to quit his bank job and sell his house to invest in a business.  Courageously he sold his house and acquired distributorship for a MNC.  Many will have business ideas, but only few will risk their time and money in investing in a new venture.  This man risked his stable job and the only asset he had.  From the time of his investment in distributorship he started to grow in line with the growth of that MNC.  There are many success stories of eminent persons.  Promoters of Amazon, Apple and Microsoft are few to name.

Fine! Now with all success stories around, we feel motivated to risk our available resources to grow our wealth.  But risk taking mechanism involves identifying and calculating the risk in investment in the particular venture or asset class.  It is not advisable to take risk blindly without any basis.  We will be discussing about this in detail in a separate chapter going forward.

Time

Now we come to another element of investment, that is “Time”.  As time changes, the objectives and goals of investment also changes.  Apart from this, the opportunities in investment world keeps changing and this warrants periodical shuffling of our investment portfolio.  Of course, change is the only constant thing in this world.  So, it is important to keep track of what is happening in investment world.  Ultimately, we need to adjust our investments according to the changing scenario.

Principles of Investments

Having understood what investment means and what is involved in it, now we need to set the principles or goals of our investments.  We invest mainly to earn profit.  When we invest for profit, we should ensure there is enough safety and liquidity.  As discussed in previous paragraph, we should identify and calculate the risk before venturing into some investment activity.  Primarily, adequate  provision should be in place to protect the capital.

In addition to safety, investors should also look for adequate liquidity in the asset class they wish to invest.  Liquidity is the ability to convert the asset into cash.  We invest to take care of our future financial needs.  To take care of this goal, it is important to assess the liquidity of the asset we are investing.

Investment in some particular assets also gives tax advantage.  Hence, people use investments to plan their income tax.

To sum up, main principles or goals of investment are:

  • Profit
  • Safety
  • Liquidity
  • Tax

1.5.Financial forecasting and planning

Now we understood what we should look for while investing.  Profit, safety and liquidity should exist in the investment we make.  Keeping this in mind now let us see how to forecast future financial needs and how to plan our investment to meet future goals.

No one can deny the fact that future is full of uncertainties.  In fact this truth is the compelling reason to forecast and plan for future contingencies.  All finance managers in corporate world indulge in financial forecasting and planning for their businesses.  However, forecasting and planning is important for individuals as well.

We will see how we can forecast and plan for our future financial needs as an individual.  When I think of planning for future, immediately the person who comes to my mind is my good old friend.  He is so smart that he had his career planned while he was undergoing graduation.  He had the target of joining a stock broker immediately after his graduation to gain experience in stock trading, and next goal was to join an organization that operates in business media.  Accordingly, he joined his preferred organization as planned and he also had target on his salary income to be achieved as he moved on.  On the sideline, he had plans of going in for higher studies and achieve doctorate. Importantly, he kept investing regularly in various assets that helped him to grow his wealth faster.  I witnessed him achieving all his financial goals.

Only few are shrewd enough to forecast and plan their future financial freedom like my friend.  By saying financial freedom, I mean the peaceful state of mind we achieve with respect to financial stress.  That is, the unexpected financial burden that comes on our way should not rob us of our peace.  To achieve this, one should start to invest a portion of earnings from the time he/she starts to earn.

First step is to forecast financial needs.  Though individual needs vary according to their background and age, the general basic financial needs are expenses to be incurred for self-education, marriage, health care, child rearing, caring for aged parents, child's education and marriage and retirement life.  Further to this, one has to keep pace with changing life styles.  Above all, one should also have investment in their agenda.

Once you forecast your financial needs that occur throughout your life, arrive at your target income you need to have over a period of time.

Identify the source of income to achieve your targeted income.  If you need to go for higher education, do not hesitate to take up a part time course.  Plan your career, don't just accept what comes to you, rather you chase your dream job or business plan.  You plan what you want to be after few years and take required steps to achieve your goal.

Budgeting is important not only for government and corporate, it is equally important for individuals too.  Plan your budget and keep track of your expenses.  Weed out the unwanted expenses and set aside more money for investment.  Be diligent in spending, know the difference between spending money to acquire an asset which has diminishing value and an asset that has appreciative value.  Also beware of the latest marketing terms used to sell the products in the name of investment.  For example, spending money for interior decoration of house is also called investing in interiors.  Remember investment means generating profit and not buying an idle asset or just spending money.

While investing your hard earned money, it is important to decide the time frame of investment based on various financial needs that occur at different stages of life.  Your investment time frame may be short term, medium term and long term.  You can split your investment into short term securities, medium term or long term securities to take care of various financial needs that arise at different stages of life.  Various asset classes with various options are available for different time frames.  We will be discussing in detail about each asset class in next module.

Key points to remember

  • Savings means just setting aside some money out of our earnings. Whereas, investment means using the saved money to purchase an asset or a business which in turn earns money.
  • Investment is vital to overcome inflation risk and tackle the decreasing purchasing power of money.
  • Inflation means nothing but “sustained increase in prices of goods and services”
  • Factors that leads to inflation are (1) Increasing demand and decreasing availability of goods and services (2) Increase in cost of production of goods and services (3) Increased money supply i.e., increased money in the hands of the people.
  • Time value of money means the decrease in the purchasing power of money.  Money loses its value over a period of time.
  • Earlier we start to invest lower the amount we need to part with.
  • Along with profit goal, investment should also have liquidity and safety
  • Should forecast the future expenses and plan investment accordingly

Roundup

Since, money loses its purchasing power over a period of time due to inflation and opportunity cost, it is important to make our current savings earn money for us by investing it in productive assets at the earliest.

We also understand that while investing, it is necessary to look for safety and liquidity in addition to profit goal.  As investment reward is accompanied by risk, it is important to take calculated risk to achieve the goal.

Finally, to achieve financial freedom, it is necessary to forecast financial needs and plan our investment accordingly.

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Comments ( 12 )

  • Marvin

    Nice initiative for Learning

  • Ramya

    It a great class,looking forward for more classes..
    It was very useful.. We learnt many things.. it in explained in a simple way with lot of stories..
    It a presented in a great manner

    • Thank you for your valuable feedback. Shortly we will release the other modules.

  • Nazira

    Very useful page. This page understands about saving and investment. Thanks to tradeplus.

  • MOHAMMAD ZAMEER

    Good returns on investment over the long term.The growth of money is also important to fulfil basic needs in our life and investing can help a person to meet long-term life goals easily.

  • Jaya

    Good way to learn and test our knowledge

  • KALIM

    Thanks for giving this article , from this i learned about difference between saving and investment.and which will give grow the money value in future. So thanks once again to give this article with example’s which can helps to understand smoothly.

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