How Much Risk are You Willing to Take?

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Series: Beginning Investing (9th post)
Section: Get Started
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Hi everyone and thanks for your patience these last couple of months. I'm kind of settled now and hoping to be able to resume my normal posting schedule.

In today's post I'd like to discuss the risk-reward equation that forms the basis for all financial planning (and possibly of life itself, but that's the subject of a philosophical discussion). Essentially, the system is based on the premise that your rewards, or potential gains, are directly proportional to the amount of risk, or potential loss, you are willing to take.

What this means is that you tend to make less money from investments that are low-risk such as government bonds, savings accounts, time deposits etc. These investments are 'safe' and you are extremely unlikely to lose any money except in really extreme circumstances such as wars or suchlike, as a result of which the gains you make are rather low. Typical interest rates would be 3-6%, which is not even enough to beat inflation.

On the other hand, you have the potential to make windfall gains from more risky investments such as stocks and art, but there is a strong possibility you might lose money instead.

Risk in itself is not 'bad'. Because an investment is high-risk does not mean it is a poor investment. The element of risk is just something you should be aware of, comfortable with and able to manage.

Managing Risk and Asset Allocation

Risk can be managed through proper asset allocation i.e. spreading your savings over a number of different investment vehicles (or asset classes) so as to reduce your dependence on any particular one. This allows you the flexibility to settle on a mix of investments that have a risk-reward profile that you are most comfortable with. This would be a weighted average of the different asset classes you select and the way you distribute your money between them.

You should do your asset allocation based on your personal inclination (e.g. some of us are inherently more risk averse and conservative than others), stage in life (e.g. someone nearing retirement would typically be more conservative than someone in his early thirties) and financial commitments (e.g. you would want your basic living expenses to be coming from a secure and dependable source such as a savings account). Ideally try to get help from a qualified financial planner who would be able to take you through a series of questions in order to identify the best risk profile and asset allocation for you.

Rough Guide to Risk-Reward for Different Investments

As a rough guide, here are the kind of returns you could expect from different forms of investment. The classifications are mine, I don't think there is any standard form of classification used generally:

• Low Risk (very low probability of losing money) e.g. savings accounts, government bonds, time deposits, gold): 3-6%
• Medium Risk (some chance of losing money, especially when buying in an overheated market) e.g. real estate, gold: 6-10% long term
• High Risk (significant chance of losing money, markets volatile) e.g. mutual funds, REITs: 10-15%
• Very High Risk (strong chance of losing money, markets highly volatile) e.g. sector-focused equity funds, individual stock picks, forex, art, hedge funds: 15-30%

The above might seem a little on the low side, especially given the kind of returns we have seen in the real estate and stock markets, but I believe these should hold for the long term.

Your personal portfolio returns will be an average of the returns above, based on your asset allocation.

Next Post on Beginning Investing: Asset Allocation and Investment Maturity

Set Aside Emergency Cash

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Series: Beginning Investing (8th post)
Section: Before You Invest
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Now that you have productively used your monthly savings in reducing your debt and purchasing adequate insurance, there is one last thing to take care of before you move on to investments - setting aside emergency cash.

Though the risk of losing your income is low, life is uncertain and any number of things may come up to disrupt the normal course of things and force you to take a break from your job. It is also possible that you may need extra cash to handle an emergency or just to take advantage of an unexpected opportunity.

For such situations, it is important to have a cash buffer. The amount you set aside is up to you, but given the primary purpose of having sufficient liquid funds to tide you over in case you lose your income, I would suggest the minimum you set aside should be enough to cover 6 months of regular expenses, as determined based on your expense analysis earlier.

These funds need to be readily accessible and risk-free, and hence should be kept in a bank account and not as a fixed deposit or in high-risk investments. You may not earn much from this money but that's not an issue.

This concludes the section on things to take care of before you invest. The main purpose of these last three posts was to ensure a fallback plan for you and your family in case of trouble, a conservative approach that will allow you to invest your money secure in the knowledge that you have provided well for the people that depend on you.

Next Post on Beginning Investing: How Much Risk Are You Willing to Take?

Insure Yourself and Your Property

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Series: Beginning Investing (7th post)
Section: Before You Invest
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Today's discussion will be on the next important thing to tackle before you start investing - Insurance.

Generally speaking, most of us equate insurance with savings, treating it as an investment mechanism. This midset is reinforced by the tax rebates we get on insurance, encouraging everyone to invest more and more in high-premia endowment plans every year in order to avail of the tax benefit.

However, the main purpose of insurance is to mitigate risk - risk of death (life insurance), risk of loss (general insurance), risk of illness (medical insurnace) or risk of untoward incidents while travelling (travel insurance).

As an individual, and a responsible householder, you should cover all of these risks when you plan your insurance, rather than rushing off to purchase more life insurance just because you get a tax break!

How Much Insurance Do You Need?

This is a fairly straight-forward question to answer:

• Life Insurance: The conventional approach is to insure yourself for an amount equal to about 10 times your annual income, which is a truly staggering sum! However, I believe this is a better way of looking at it. I also subscribe to the concept of layering your insurance plans so that you can increase your insurance amount over time till a point, after which it starts to reduce because you have saved a good amount by then and might not need so much insurance
• General Insurance: Insure your house (an option that generally is offered with many home loans nowadays - go for it) and your valuables. Burglaries and other mihaps happen and you'll sleep much better knowing that you have a fallback option. There'n no reason for you to learn this the hard way as general insurance premia are really low and definitely well worth the benefit!
• Medical Insurance: In general, try to get yourself and your family covered for major illnesses and surgeries. Some banks, such as Andhra Bank, offer a floating cover that can be shared by the entire family, which I think is a very useful facility as it saves the trouble and expense of insuring each family member independently
• Travel Insurance: This is a must while travelling. If you are abroad and things get stolen, your personal funds will not really help much, I can tell you!

A Bit on Life Insurance

There are two basic kinds of life insurance policies: endowment, wherin it is a risk cover cum saving scheme (this includes money-back policies, unit-linked insurance etc) and term assurance , which is a pure risk cover. The returns on your investment in the former are generally worse than you can do with other comparable investments in the market so I'd always recommend term assurance as the best form of life insurance. It has the added advantage of having very low premia because you need not invest anything in savings. However, due to its nature, the entire premium is an expense. Once you pay it, it is gone and you will not get it back unlike in an endowment policy.

Next Post on Beginning Investing: Set Aside Emergency Cash

Plan to Bring Your Debt to Manageable Levels

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Series: Beginning Investing (6th post)
Section: Before You Invest
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So far you have accomplished two important things - you've set your goals and also determined the amount of money you can save / invest every month in order to achieve them.

It is time now to start doing the preparatory work towards creating a sound financial plan. This section, 'Before You Invest', will consist of three posts:

• Bringing your debt to manageable levels
• Insurance
• Setting aside a emergency cash

Today we'll be talking about the first of these.

Good and Bad Debt

Most of us have debt of some sort: car loans, personal loans, home loans / mortgages, credit card outstandings or just money we've borrowed from friends and family. This is in itself not such a bad thing. After all, loans serve the important pupose of letting us buy into things today that we could otherwise never afford.

The trick, however, is to distinguish 'good' debt from 'bad', a concept that I first read about years ago in the book 'Rich Dad, Poor Dad' and which has stuck with me ever since. Essentially, any debt you take on towards buying an appreciating asset (something that increases in value over time) is 'good' and any debt you take on to purchase depreciating assets (like cars, appliances etc.) or consumables is 'bad'. The idea here is to minimize bad debt and increase the amount of good debt in your portfolio.

Note that I am not talking about eliminating bad debt completely, which is probably impossible in real life. Everyone would like to buy a car or a nice TV or refrigerator and it's rather difficult to do these without taking a loan of some kind. Just understand bad debt for what it is - a drain on your savings - and work out ways to reduce this by postponing your purchase or perhaps settling for something a little less expensive.

The balance to strike here is between your current lifestyle and your future and it is up to you how much you sacrifice now so you can enjoy later. Just be aware that the more you live it up today, the less you will have for tomorrow.

'Good' debt, on the other hand, is a pretty neat thing to get into. You purchase an asset at a price locked in on the date of purchase and reap the benefits of all the profit the asset makes you over time.

How Much Debt Should You Have?

In general, most banks will not allow you to borrow any amount for which the total of your monthly instalments across all your loans will exceed more than half of your income. Most people stretch this even further by taking loans from different banks and not declaring their outstanding loans elsewhere. This is definitely too high for comfort and will leave you in a desperate position in case you were to lose your income for some reason.

I'd suggest perhaps 30% as the limit, and this includes all your debt, including any amount you are rolling over on your credit cards.

How Should You Reduce Your Debt?

Start by listing all your loans under the 'good' and 'bad' categories and, for each loan, list the annual interest rate you are paying. For credit cards, this would typically be about 40% (@ 3% per month interest), which makes it the most expensive loan you could take!

Based on the monthly savings you have already calculated, plan on pre-terminating the more expensive (higher interest) 'bad' loans. Focus on this first rather than on investing your money as this will also significantly increase your savings potential as your interest payments go down.

Further, explore the option of taking on lower cost loans to pay off higher cost loans e.g. taking a personal loan at 18-20% to pay off your card outstandings (which are at about 40%), transferring your card balance to another card to avail of balance transfer incentives, taking a top-up loan on your property (at about 9-11%) to pay off your car etc.

Especially on the subject of credit cards, if you have multiple cards with outstandings on each, plan on paying them off in the following manner:

• Pay the minimum due on all cards except the one where you have the highest interest. If all cards have equal interest, then choose the one which has the highest outstanding
• For this card, use your spare funds to pay off as much as you can
• Do this every month till you have paid off the first card. Then cancel the card
• Move your focus on the next highest interest or outstanding balance card, paying off as much as possible on this while maintaining the minimum due on the others
• Continue till you have paid off all cards. Retain only one or two cards at a maximum

Have a Plan and Stick to It

Based on the above, create a 'debt-reduction' plan and stick to it, trying to minimize or eliminate 'bad' debt over time, thereby creating a larger monthly savings base with which to start investing once your debt is down to manageable levels.

Next Post on Beginning Investing: Insure Yourself and Your Property

What Are Your Goals?

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Series: Beginning Investing (5th post)
Section: Setting Your Goals
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OK, so now you know how much you're worth, the amount you spend and the amount of money you can put away every month to meet your goals.

The question for this post is - what are your goals? And remember, these are goals you are defining, not dreams or visions like 'I want to retire rich on a little island in Spain'. They need to be tangible and down-to-earth.

There are three things you need to define for each of your financial goals: what you need money for, when you need it and how much you need. An example of a goal would be 'I need Rs. 5 lakhs to pay for my son's wedding 5 years from now'. Since it is tough to predict how much prices will rise over a long period of time, it would be easier if you just work out the funds you would need to fulfil the requirement in today's prices. You can work out the inflation-adjusted requirement later.

Sit down with your family and work your goals out in some level of detail. After you have these settled, re-order them in a chronological format, with the nearest goal first and moving down to the goals that are furthest out.

When planning your goals, do ensure you consider the following:

• Childrens' education: Lumpsum amount to pay for a good college / post-graduate education for your kids
• Weddings: Lumpsum amount to pay for your childrens' wedding(s)
• Home purchase: Lumpsum amount to pay for an outright purchase or down payment on your own home plus furnishings etc.
• Financial freedom: A point in time at which your average monthly spend should be accounted for purely out of passive income i.e. income from your investments. For more information on this, please read my earlier post on this subject
• Retirement: How much money you need to retire so that your retirement egg will sustain you for the rest of your days

This first draft of your goals might change a bit based on how much you can realistically invest and on the level of risk you are willing to take, but that is the subject of the next post. Also, do note that these goals will probably change from time to time, depending on your stage in life e.g. you might start planning for your childrens' education once you start a family, a requirement that may not have been in your plans earlier.

But, for now, give yourself a pat on the back for getting here. You now have the entire foundation laid for building your financial plan, not a mean achievement at all!

Till next time, happy investing!

Next Post on Beginning Investing: How Could You Achieve Your Goals?

How Much Could You Save?

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Series: Beginning Investing (4th post)
Section: Setting Your Goals
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Now that you know how much you spend sit down with your family and work out where you could reduce your expenses. There are usually some useless expenses that you can cut without feeling the difference.

A good place to look for saves is in utility bills like electricity and telephone. It might also be possible to reduce in areas like credit card late payments and interest expenses (just pay before the due date, take an instalment loan scheme on the card or transfer your balances to another) and some entertainment expenses (no, I'm not asking you to sacrifice it all - maybe you could just reduce it by, say 10%?)

Once you have 'cut out the fat', you are now in a position to determine how much you could save every month - your monthly income less your monthly spend. This should, at the very least, be a positive figure otherwise you are definitely living beyond your means. Ideally it should be around perhaps 20% of your income or better. I think that's the average savings rate in India.

Your monthly savings are pretty much all you have to count on when you set your financial goals so the larger the figure you can mange, the better!

Next Post on Beginning Investing: What Are Your Goals?

How Much Do You Spend?

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Series: Beginning Investing (3rd post)
Section: Set Your Goals
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Ok, so now have taken the first step on your journey to wealth and financial freedom and you know what you're really worth. And you're ready to start working out your goals and figuring out your financial plan, right?

Wrong.

Before you move on to all the cool 'banker' stuff, it is important to figure out how much you spend. Without this information, all your goals and planning will just remain utopian dreams, your financial plan will not deliver the results you want and you'll eventually be discouraged into giving up the whole thing.

Keep an Expense Diary

The best way to work out your expenses is to maintain a log of your spending every day for at least two to three months, ideally a lot longer. If you're married, have a family or are living with a partner, do this at a household level i.e. maintain a diary of all personal as well as common expenses for the entire family.

Basically, at the end of every day write down your expenses in a little notebook. At the very least, the notebook should have columns for date, expense description and amount (ideally also add columns for expense category and person responsible for the expense) and you should add up the amounts spent every week. It takes 5 mins every day and is well worth the effort.

[When creating categories, make sure you have enough to cover the entire spectrum of expenses in a manner that will allow for meaningful analysis i.e. not too many or too few. I would suggest you set up 7-10 categories as a good number]

Remember to add in credit and debit card expenses as well as spends made through other non-cash means such as food coupons (like Sodexo, Ticket etc.)

For non-monthly outgo such as insurance premia or one-time purchases (like appliances etc) either maintain your diary for a long period and record these as you incur them or make a conservative (implies you should take a pessimistic / worst case) estimate of your annual spends, divide by 12 to reduce it to a monthly value and add it into your expense diary as a 'virtual' expense in an appropriate category.

Analyze Your Expenses

If you're somewhat comfortable with spreadsheets, create one or download the one shown here from the Journey to Wealth group to help you create cool graphs and charts that show you just how your expenses break up by category, when the peak spending times are every month, what your average monthly spend is and how your expenses change over time.




Believe me, if you haven't done this before, it's really fun - not to mention it gives a really professional feel to this entire personal finance thing and gives you the satisfaction of getting something done.

If you aren't great with spreadsheets, just manually calculate your average monthly expenses because this is the basic information you need for financial planning.

Testimonial

My wife and I kept such a diary for almost a year. We started because we really needed to find out where our money was going as somehow we never seemed to have any at the end of each month!

It gave us a wealth of information on our spending habits e.g. we discovered we were spending a lot on electricity (the AC was on all the time), telephone bills (we lived away from our parents) and pizzas (that was me) and were able to reduce the spend in those areas significantly. The money we saved went partly into investments and partly into living the good life (a regular Saturday night out). Everybody won!

It is possible you'll read this and think you can already estimate your spends, but that's usually not good enough because you'll invariably miss out some regular (not necessarily monthly) expenses. If you're very sure, keep the diary for a short while but don't skip this step. I can almost guarantee you will be surprised when you maintain this record for a while

***I would like to acknowledge Prasanth for providing some of the material for this post***

Next Post on Beginning Investing: How Much Could You Save?

Addendum Squared!

Sorry about these repeated post-scripts, but I've just figured out how to use Google Groups to upload templates and other tools that you can use to jump-start / accelerate your journey to wealth.

Here's the link to an Excel template you can use to calculate your net worth. All data are fictitious, and intended to illustrate how the sheet can be used.

If you are not familiar with pivot tables (used in the template), please just create standard charts for your analysis. I'd appreciate it if you could send me across a copy so everyone can benefit from your efforts.

Thanks and hope you like this new feature. I'm going to use it as often as I can!

How Much Are You Worth - Addendum

This is to acknowledge some excellent inputs provided by Prasanth in his comments on the previous post.

To summarize:

• Remember to include your Provident Fund (or 401k or equivalent) and surrender value of insurance policies in the assets column
• If you have reverse-mortgaged your property (taken a loan against your property or used your property as collateral for anything, including top-up loans, home improvement loans) include the amount of debt you have taken on as part of your liabilities.
• Prasanth prefers not to include his primary residence in the asset side at all since it is not, strictly speaking, an investment (after all you need a place to stay) but I'd prefer to include it anyway. Not many of us will own more than one property and, if you've had the sense to make a good investment, you've earned bragging (and 'asset-column') rights to it!
• Both Prasanth and I agree on not including inherited property because we tend to favour wealth creation over wealth inheritance, believing that you should add to what your forefathers left you, rather than living off it. But that's a matter of personal choice

I hope you have completed this exercise (or soon will) because I'll soon be back with the next post in the series and then there'll be more 'homework'!

How Much Are You Worth?

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Series: Beginning Investing (2nd post)
Section: Set Your Goals
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Now that you're sufficiently pumped up to start on your own journey to wealth, here's a fun task for you - calculating how much you are worth today!

In performing this calculation, we will use a very strict and narrow definition of assets, considering only those of your things that hold or appreciate in value over time rather than the accounting definition which assigns a value to everything you own. The reason for this is that we're trying to arrive at the most conservative and true assessment of your net worth rather than a value that will reduce over time due to depreciation.

[You could add in the value of your goods to make you feel better if you like, but do remember that these will reduce in value over time and will not contribute to your financial goals. After all your surround system will not really fetch much ten years from now if you want to sell it to meet your financial goals! And, what the heck, your net worth is for your eyes only so where's the point in inflating it?]

The calculation is fairly easy:

• First, work out the total value of your assets (things you own that meet the definition above). This would include cash in bank accounts, stocks, mutual funds, property, gold, fine art, jewellery, foreign exchange, antiques and other valuables (and even the spare change in your drawer if you're sufficiently desperate!). To be really conservative, take a reduced value for the more volatile assets like stocks and equity funds to account for a possible fall in value. You could discount them by, say, 20-30%.
• Then total up your liabilities (what you owe to others). This would essentially include all kinds of loans like your car loan, housing loan, personal loans, credit card outstandings etc. Be true to yourself and count everything you can think of.
• Subtract your liabilities from your assets to get your net worth

The above ignores the value of your car and other worldly goods and it paints a very stark, but true, picture of your financial health.

All too often, we feel well-off because we have nice things, a rockin' night-life and a cool car but in reality, we're just a mis-step away from trouble. And like the picture of Dorian Gray, this 'net worth' calculation presents us with what the ugly truth really is!!

If you find you have a healthy positive balance from the above calculation, pat yourself on the back. You're already well down the path to financial freedom.

And, if you find you're in the red, don't despair. A bit of discipline and you'll soon be in positive territory, after which it's just a matter of time before you're watching your moolah grow before your very eyes!

Next Post on Beginning Investing: How Much Do You Spend?

You Need to Start Investing - Right NOW!

Welcome to the first of my posts on beginning investing. If you’re reading this with any degree of interest, it’s probably because:

1. You have a decent amount of money in your savings account and you know you need to do something with it but you’re just too busy and don’t have time for it just now. You’ll get to doing something next weekend. [You’ve been saying that for six years now]
2. You have a friend who gives you hot stock market tips, several of which have shot through the roof while you stood by and watched him laugh all the way to the bank. You’d like to take a punt on the stock market but you’re not sure whether to risk it.
   [The right, though fairly useless, answer at this point is – it depends. But you’ll be able to answer it before we’re through]
3. You have all the good things in life, but no savings to speak of even though you earn quite a decent sum (Come to think of it, you wonder where your salary goes every month…). But there’s that new surround system on the market you need to buy tomorrow, after which you’ll be pretty much broke so you’ll read this now and promise to get started next month
   [You’re in more trouble than you can imagine, my friend. Forget the surround system and start focusing on saving something RIGHT NOW]
4. You earn a reasonable, though not high, salary and you’re wondering whether it is even possible to get rich with what you get [Given time and patience, yes, you can become pretty well off]
5. You want to start out, but you don’t know enough and need some step-by-step directions. [Well, I’ll try my best and hope you can make use of what I have to say]

While the circumstances of each of the above types of people might be different, what is common to all is inertia and / or inactivity – and yes, a general interest in the subject. However, the only 'interest' of any importance in terms of money is the type you get from your investments. Plain enthusiasm and intellectual pontification will get you nowhere. You must get started – TODAY!

And here’s why:

• Bank savings accounts and fixed deposits earn between 3-6%, on an average, a rate that is, at best, keeping up with inflation (inflation is the rate at which prices in general are rising every year). This means that, over time, you are getting POORER. Not only are you not moving forward, you are actually moving BACKWARD and, when the time comes for you to retire, you will realize that you cannot. You will have to continue working your whole life to support yourself and your family
• Even if you are looking at the quantum of money you will have, rather than purchasing power (though that’s no use, really, due to the fact that prices are also rising due to inflation and a lakh ten years later will not be worth as much as a lakh today), please do note that 3% interest in savings accounts will imply your money will double in only about 24 years (I am not joking). Do you really want to wait that long to see the Rs. 20,000 you have in your savings account become Rs. 40,000? Especially when it will buy probably the equivalent of Rs. 10,000?
• Interest rates on government-backed investments like PF are falling and will continue to do so till they reach market rates of interest i.e. around the same levels as RBI bonds. This is because the government cannot continue to pay out artificially high rates of interest while earning less than it gives you. Such a system cannot be sustained indefinitely. If you doubt this, I’d like to draw your attention to National Savings Certificates and Kisan Vikas Patra that used to pay out around 14% in the ‘90s (doubling your money every five years) whereas they are now around 6.5% (doubling your money only in around 11 years). Even the PF rate has come down to around 8% and will continue to decline despite the opposition of various parties in the Indian government
• Prices of real estate are going up to stratospheric levels. Chennai, the city whose property prices I am most familiar with, has seen price rises of around 30-100% per year in the past 2-3 years, depending on the area. They have reached a level such that a budget of Rs. 20-25 lakhs would be about the minimum you need to get anything decent (good residential neighbourhood, 2 bedroom) in the city. Prices in the crores are now commonplace. Chances are, if you’re buying an apartment ten years from now with the money you have in savings accounts, you will need to move to towns that you haven’t even heard of today!

I'm sorry if the points above seem harsh, but those are the facts. And that's why you’ve really got to get started right away. There will always be excuses for putting off investing (let's face it, it's not exactly fun) but I can assure you that the hard work is only in the beginning. After that, for most of us, a disciplined approach to investing can run almost completely on auto-pilot.

Last (but this could have just as well been the first point) the magic of compound interest really kicks in when your investments have time to deliver returns. All else being equal (and sometimes even when things are not quite equal) the earlier you start, the richer you will be. Investing is one of the areas where the fable of the 'Hare and the Tortoise' really rings true.

Give your money time and, even at low rates of interest (yes, you do not need to invest in stocks if you don't want to), you will probably do better overall than many, many people who've made a quick buck in the current bull run, myself included.

Just get started! It’s that simple.

Next Post on Beginning Investing: How Much Are You Worth?

Series on Beginning Investing - Coming Soon!

Based on the poll results till date that indicate a demand for material on beginning investing, I will be devoting several posts to the subject in between my articles on other stuff.

I will be tackling the subject in five parts, based on the order in which you need to go through it:

1. You Need to Start Investing - Right Now!
2. Set Your Goals
3. Before You Invest Anywhere
4. Get Started
5. Manage Your Investments

Based on my experiences and those of many of my friends, I know the hardest part is getting over the initial intertia and our natural tendency to procrastinate on money matters. The solution is to just start doing it! And I hope the step-by-step approach I will be laying out will be making it easier for you to start off on your individual journeys to wealth.

If you are new to this and feel the need to make your money work for you, do bookmark this site and come back in a few days to check out the first of my posts. I will space out the material to let it sink in and allow you some time to work on what you learn before coming back to read the next instalment. The reason for doing this is so you get a chance to clarify your doubts before moving on. Please feel free to get in touch with me over email or leave me your comments so I can try to tailor the content to what you really want to know about.

I'm pretty excited about this series and I really hope it's of use to all of you out there.

Next Post on Beginning Investing: You Need To Start Investing - Right NOW!