Basics of Smart Investments

Recently on a trek, one of my friend asked me a simple question, which lead to a very basic discussion on investments. It included matters like things to avoid and things to choose. For the benefit of all, I reproduced the entire dialogue between us. I would be glad to receive views and things to add to it. Happy reading!

“I’ve idle funds lying in my savings bank account. What should I do?” asked my friend while I managed to penguin-walk on the Chaddar Trek.

I visualized this is a very big problem and I genuinely wanted to help my friend. Hence, our discussion started even on a holiday. Our education system teaches us to “earn”. Definitely, earning is important. But, more important than that is to “save”. And even more important is to “smartly invest”. The problem is that it is not taught in any school, college or even at home. Mere investment of Rs. 2,000/- to Rs. 5,000/- per month turns into crores after 20-30 years, if smartly invested.

I responded to my friend, “Have you not already started investing?”

“I did. I lost a huge chunk in the stocks. Now I am afraid. At what age should one start investing?” asked my friend.

“As early as possible. Ideally, you should have started at the age of 18 or even earlier, be it in small amounts. One should never underestimate the power of compounding.”

My friend enquired, “What is compounding? And why is it so powerful?”

I explained, “Compounding means earning income on income. Say you invested Rs. 100 on which you earned income of Rs. 20 in the first year. In the second year, you will not only earn income on original Rs. 100, but also on Rs. 20. This will continue to add each year. Financially, it’ll make huge difference in your life, if you start early.”

“I earn interest on the savings bank account. Is it not a sufficient investment?”

“That is the biggest blunder you can make in your life,” these words were necessary for enlightenment. “Do you know how much interest you earn on amount lying in savings account? Just 3%-3.5%. Now, average inflation is 6%. You are losing money due to that.”

“Is it! By the way, what is inflation?” he asked.

“Petrol price today is Rs. 78/-. Twenty years ago, the same was around Rs. 23/-. This means your purchasing power has reduced. This is inflation.”

“Then should I invest in Fixed Deposits with Banks?”

“Ofcourse! Atleast it’ll beat the inflation rate and value of your money will remain intact.”

“But my funds will get blocked in Fixed Deposits. What if I need funds immediately?”

I replied, “Use the thing between your ears. Calculate your monthly outflow of money, multiply that by six. You should be having six months’ expenses in liquid form, i.e. your regular savings account. The excess should be invested. Also, you should make FDs of different duration, maturing at different times and with different banks for obvious reasons you know.”

Satisfied with the calculation, my friend moved to the next question, “You said saving is important. I really negotiate hard with auto-wala and local vendors selling fruits, vegetables etc.”

I saw that coming from him. I replied, “That’s not what is called as savings. Reducing your expenditure is not savings. But biggest savings where you need to focus is avoiding wrong decisions which lead to huge monetary loss. Wrong decision of a thousand becomes loss of lakhs in few years and loss of crores in another few years.”

He looked confused, “Can you explain how?”

“Sure, have you taken Insurance?”

“Umm no, but I have read about endowment plans and ULIP. That seemed an attractive investment to me.”

I asked, “What do you know about them? Please tell me.”

“Just that it looks attractive in terms of returns and has a life cover too.”

I was waiting for this answer, “There you are. You know only one aspect of it. In endowment plan, you pay a huge amount each year and you get a lump sum amount after specified number of years. It looks attractive to pay 20-30K per year for 20 years and receive 20L at the end of period. In my opinion, it is the most foolish step one can go for if he does not know completely about it.”

<Silence>

I continued, “Have you taken term insurance?”

“No.”

“In my view, term insurance is the first thing one should take from the day a person starts earning.”

He exclaimed, “If it is so important, then why no one takes it? Why is it not so famous?”

“The reason is simple. No Insurance Agent, Banker, Portfolio Manager or any of your friends would ever promote term insurance. The commission they earn on term insurance is almost negligible. Whereas Endowment Plans and ULIPs fill their pockets well. The commission in such cases is as high as 30% of the amount you invest. So, if you pay an Insurance Premium of Rs. 50,000/-, Rs. 15,000/- straight away deducted from your money and directly goes in the pocket of the agent (Be it your friend). This Rs. 15,000/- is your hard earned money. Just imagine you lost Rs. 15,000/- cash kept in bag in local train. How does this feel? Does it hurt? However, while taking Endowment and ULIP plans, you don’t feel that hurt directly since you are not aware what has happened with your money.”

I glanced at my friend, he was in thoughtful state. I continued, “I am not against insurance agents, bankers and portfolio managers. They are just doing their job. I am generalizing just to make you understand the reality. You will definitely find good people amongst them. My purpose is to make you understand the concepts.”

Shocked to hear, my friend asked, “What is a term insurance?”

“I am glad you asked. It is a pure form of insurance. You pay a small amount every year for specified number of years and you get nothing in return ever. No money is ever paid back.”

“Nothing? Why should I go for it then?”

“If a person has a conventional mindset, he’ll never understand the reason to go for it. Let me ask you a simple question. What is Insurance and why should you take it? The basic answer is - if anything happens to you, then the grief of loss of your life will remain with the family but you are making sure that your family does not suffer financially even in your absence.”

He laughed, “Come-on! What can happen to me at this age?”

I looked in his eyes and said, “Observe around you. You are walking on one of the toughest treks. Also, no one ever thinks that anything can go wrong with him, but we see deaths at the young age, don’t we?”

He nodded.

I continued, “I do not wish to scare you. I’ll explain this with the help of an example. Say you are earning anywhere around 30K to 50K per month. You have set a budget to invest Rs. 50,000/- each year. If you take endowment plan, you will get an insurance cover of Rs. 10-20L for a yearly premium of Rs. 50,000/-. On the other hand, if you take a term plan, you get a cover of Rs. 1 Cr for a yearly premium of Rs. 10,000/- (depending on your age).

Now suppose you die. If you had taken endowment policy, your family would get Rs. 20L on a higher side. If they invest such 20L in FDs with banks, they will earn interest income of Rs. 1,40,000/- @ 7% pa. which is not even Rs. 12K per month. However, if you had taken a term plan, your family gets Rs. 1Cr on your death, on which they will earn almost Rs. 60K per month. This is equivalent to your current salary. Do you understand the difference?”

He nodded.

I continued, “We never brainstorm on such things and believe what is told to us from any source. Be it an agent, banker or a friend or even an online video.”

“I understand.”

“Have you ever noticed you get a call from your banker to invest here and there whenever you have high balance in your savings account? They will offer you ULIPs. For whose benefit? I am sure you know the answer by now. To conclude, understand that Insurance is for life coverage and not to get back premium and returns on it. Period.”

“I agree. I understood the real saving is Rs. 40,000/- by taking Rs. 10,000/- term plan out of total investment budget of Rs. 50,000/-. Should I take a Health Insurance as well?”

I immediately replied, “Health Insurance is must. You work extra hours putting your heart and soul. You work for 15 years and save Rs. 10-20L. Now, if any of your family member gets admitted in the hospital, you know in how many days the savings of 15 years will wash out. In a week or maximum 15 days. Can you relate to this practically?”

“Yes.”

“Then why have you not taken health insurance till date?”

<No Answer>

“First thing you will do after returning from the trek is to take mediclaim insurance for your entire family. I hope you understand the importance of mediclaim policy. All the insurance you select should have a higher claim settlement ratio. As of now, I am not even talking about the tax benefits you get out of it. They are the incidental advantages.”

He said, “I totally agree with you. My whole life savings will vanish in front of my eye in the absence of mediclaim. Additionally, I may need to borrow funds from friends and relatives. Taking Loan will mean I will never be able to save any money in my whole life. My entire earnings will go in repaying the debt. In case I make a default in repayment, my years old personal relations will get ruined.”

I smiled, “Now you are on track.”

He asked, “What is the one thing you will advise me to stay away from?”

“Quick Money,” I replied immediately, “Whenever you hear things like Invest this much now, after a particular time, you will double your money. Just run away from there. Never ever consider such schemes in the market. Lakhs of people have lost their money in such schemes.”

His curiosity increased and asked further, “Now, I saved money by taking right decisions. How do I invest the same? What options do I have other than Fixed Deposits with Banks?”

“Have you invested in Mutual Funds?”

“No.”

“Why?”

“I don’t know about it and I am scared. What if I do not get my money back?”

I smiled, “It is true that mutual fund investments are subject to market risks. But it is not a scheme. It is regulated by SEBI. No one is going to run away with your invested money. It is comparatively safe. You just need to play smartly.”

“What action can I take today?”

“Calculate the six months expense as I explained to you earlier. For the excess, start investment by way of SIP. Don’t jump directly into stocks unless you have a deep knowledge of the market. Further, never listen to any tip or a story. If you do, your entire investment may become near to zero. As they say, never put all your eggs in the same basket.”

He asked, “Can you elaborate?”

I said, “Sure. Diversification is the simple answer. You earn 7% on Bank FDs and inflation is 6%. This 1% is not enough. But you also can not risk your entire money into high risk investments. Hence, I suggest you invest half of your money in safe securities and balance in high returns investments having higher risks.”

“Is there any alternative to Bank FDs?”

“There are few company deposits having AAA ratings by CRISIL and ICRA. This means they are highly secured. You may get 9% interest on these company deposits. The gap of 9% of Company deposit and 7% on Bank FDs may seem smaller now, but if you add compounding effect, you cannot even think in your wildest of dreams the worth of it in next 20 years.”

“Ok, so they are as secured as Bank FDs.”

“Correct. Also, you can go for RBI bonds which are considered totally risk free and they pay interest 1-2% higher than the regular Bank FDs. It is most secured form of investment. Currently, they carry interest rate of 7.75% pa. You can choose to get payment of interest each year or you have an option to accumulate the same.”

“I should definitely have RBI bonds in my portfolio to manage the risk. How do I choose mutual funds? There are thousands of them in the market.”

“Choose large-cap equity fund. You need to check the ratings of the mutual fund you are planning to invest in. It should have atleast 4 star or 5 star ratings in all the websites. Avoid mutual funds with 1 or 2 star ratings. Start with SIP of such chosen mutual funds for 20-30 years.”

“Why do you call SIP as smart investment?”

“This is because whatever is debited from your bank account gets directly invested. Nothing is deducted from it.”

“Is there only one way to invest?”

“You have two options. You can do it on your own as above or you can do it through a good broker. If you do on your own, you’ll save approximately 1% broker’s cost. However, a good broker will help you recover his cost and even earn extra for you. Ultimately, you are net-net benefitted. I would still suggest you to brainstorm yourself and invest wisely.”

“Yes, I understand that it’ll take few minutes or hours to take such decisions, but such decisions will decide my net worth in coming 20-30 years. One more question, why did you suggest me to invest in mutual funds, rather than stocks directly?”

“With limited funds, you can invest in maximum 4-5 stocks. But, Mutual Funds may invest in 50 companies. Suppose, even if one of the companies shut down, its contribution to total investment is very less so if you had invested Rs. 100/-, it’ll become Rs. 98/-. That is the only risk. Whereas, if you had invested directly in the company which shut down, it may have become zero for you.”

Convinced, he further enquired, “What if value of Mutual Fund goes down after I invest in it? There is no limit how much it can go down as per the limited knowledge I have. In case of FD with Bank, Interest rates may go down but value of FD does not go down. How do I tackle a going down of the mutual funds value?”

I created a suspense, “What if I say, even if the value of your mutual fund goes down, you can gain from it?”

He laughed, “Crazy!”

“Yes, I know. Firstly, you need to keep a basic track of the market and its whereabouts. Identify peak of the market and low of the market. Invest in the Large-caps accordingly. Now, after some period of time when market is down by 20%, large-cap stocks will be down by 20% but mid-cap will be down by 50-60%. Which implies you can get mid-cap cheaper. So, exit from large-cap and invest in mid-cap. Remain invested until market reaches a new peak. When it is at peak, exit from mid-cap with huge gains and again invest in large-cap. Keep identifying new peak and new low to continue this game of investing.”

He exclaimed, “Wow, from where did you learn that?”

“This is the strategy of Warren Buffett. He says when the market is greedy, fear. When market is fearful, become greedy. This means when market is going up and up, people generally become greedy. But you should fear it. On the other hand, when market goes down, people will leave mid-cap and that is the time you enter the mid-cap. Now whether market goes up or goes down, you are into profit. In fact, you will wait for the market to fall and make profits out of it as well.”

“I think I got the idea but will understand only when I do it practically. I’ll start with small to experiment. Is there any option to invest for my daughter?”

“Yes, there is an excellent investment option under government scheme named Sukanya Samriddhi Yojana, wherein you can invest up to a maximum of Rs. 1,50,000/- in a year and you get returns which almost touches 9% p.a. A big corpus can be given to the daughter for her higher education.”

“Wow, that’s great. If one understands these basic fundas, he will celebrate even when the entire market is crying. One last question. Can I be financially free even if I earn an average income throughout my life?”

“I told you in the beginning itself. How much you earn will matter less than how much you save and smartly invest. Let’s take an example, you are earning 50K per month and you grow your income by 7.5% each year. Your colleague earns 1.50L per month and he grows his income by 10% each year. You invest smartly and he does not save much and takes wrong financial decisions. After 20 years, you will be financially free and your colleague will be in debts. Inspite of earning so much, he will need to borrow money. On the other hand, you will be in a position to lend the money. That is the power of smart investing. Earning money through money is an art. It is like a story of the Tortoise and the Hare.”

A look of satisfaction on his face, “I totally agree.”

I laughed, “Happy Investing!”

Disclaimer: The content of this document is just a piece of communication between the Author and his friend. No assurance is given that the views expressed herein work scientifically to make smart investments. The views of the Author are based on his own experiences and market conditions, which are subject to change from time to time. The Author does not assume responsibility to update the views consequent to such changes. The facts and figures used in this document are not actual but only an approximate. The purpose is to convey the concept and not to calculate the actual returns. The actual facts may vary. It is only for the purpose of education providing only general information on the subject and is not an exhaustive treatment of such subject. The Author does not intend to hurt any sentiments of investment advisors, agents or bankers. The Author is not by any means providing any professional advice or service. This information is not intended to be relied upon as the sole basis for any decision which may affect you, your business or any third person. Professional Advice should be sought before making any decision. The Author does not want the reader to follow the view or advice written in this document. The Author shall not be liable to any person for any claims, liabilities or expenses whatsoever sustained by any person who relies on the contents of this material.