Thursday, May 14, 2009

10 Investment Basics

Start early
Investing is easy once you know how. That’s why starting early gives you an extra edge, to learn from mistakes and experiment with various investment techniques and asset classes. As you grow older, you can take limited risks with equities and would prefer to invest in debt too.

Also, every year that you postpone investing towards retirement, the annual savings you need to make to reach your financial goal will keep on rising. For instance, to get Rs 10 lakh at the end of 20 years, if you start now you will need to invest Rs 13,879 annually but if you start 10 years later, the annual investment will shoot up to Rs 56,984.

Know yourself
Invest in shares or mutual funds based on your needs and after doing proper homework. Don't buy something because your neighbour believes he has a winner on hand, or your broker is issuing a big buy report on a stock.

Carefully choose securities that fit your profile. It is important to relate the risk perceived in a given security not only to returns, but also to your attitude towards risk. It is important to understand your emotions towards money and comfort levels with risk. For instance, what would be your reaction if your stock investments plummet by 35 per cent in a month? How would that affect your medium term or long term plans?

The risk/return trade-off
There is no harm in assuming a big risk in the quest for higher long term returns, and your profile does not preclude taking of such risks. Equities promise higher long term returns but the period taken to realize these returns too can be uncertain. As far as debt mutual funds are concerned, they are more stable tenure but returns are much lower. As an investor, you should be able to judge whether the perceived risk is worth taking in order to get the expected return and whether a higher return is possible for the same level of risk (or a lower risk is possible for the same level of return). Smart investing will involve choices, compromises and trade-offs. And you have to decide the combination of factors that suit you best.

Don't overpay for growth
Seek out shares that are capable of delivering sustainable earnings growth but don’t fall into the trap of overpaying for growth. Even the best growth stock may not deliver dream returns if your purchase price was too high to begin with. Warren Buffet, one of the most successful investors in the world, said back in 1983: "For the investor, a too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments." So growth riding on the back of a reasonable purchase price may be a good motto to stick with.

The reinvestment risk
If it suits your plan, choose a fund that reinvests your dividends or interest. That won't leave you exposed to the risk of reinvesting the amount at equivalent or higher returns for the same level of risk. Such alternatives are more than often not easily available. The reinvestment risk is implicitly defined for a debt instrument. Yield-to-maturity, which is the actual yield on a bond if held to maturity, may be a familiar term to those who invest in fixed income. But few know that this YTM assumes that each interest cheque received by the investor is reinvested at the coupon rate. In reality, however, most investors are probably spending this interest on fullfiling current needs. So even if investors are getting a coupon of 18 per cent on a semi-annual debt instrument, their YTM is much lower.

Beware of the law of averages
The average, or mean, acts like a powerful magnet that pulls stock prices down sharply, often causing returns to deterioriate after they exceed historical norms by substantial margins. Stocks display runaway tendencies by appreciating sharply. Subsequently, prices may plateau causing disappointment. In such a situation, investors may profit from selling out earlier than originally planned. And if the fundamental story is still intact, you could even buy back your shares at a lower price. So stay tuned to any short-term movements in the stock market that affect your stocks. However, if your goals are long term, don't get into the trading mode, where you compromise on the big picture for short-term gains. It is important that you still think long term. As Benjamin Graham, author of the investment classic The Intelligent Investor wrote: "In the short term, the stock market is a voting machine-reflecting a voter registration test that requires only money, not intelligence or emotional stability-but in the long run the market is a weighing machine.

A trend may not be your best friend
The psychology of the stock market is not only based on how investors judge future events, but also on how they react to the immediate past. There is a tendency among common investors to buy shares of those companies or sectors that have performed well very recently. It is critical that you assess where you are in the cycle during any bull run. That's because what may seem to be an everlasting phenomenon eventually turns out to be illusory. It will be replaced by another, equally compelling one. And as an investor, you are left with shares bought at the peak of a cycle.
Like Burton Malkiel, the author of A Random Walk Down Wall Street has to say: "It is not hard, really, to make money in the market… What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges."

Time marches on
Time can dramatically enhance the value of your starting capital through the magic of compounding. At 10 per cent annually, the annual incremental capital accumulation on a Rs 10,000 investment is Rs 1,000 in the first year, is over Rs 2,300 by the 10th year, and just under Rs 10,000 by the 25th year. After 25 years, the total value of the initial Rs 10,000 is Rs 108,000, a ten-fold increase in value. Give your investment all the benefit of time that you can afford. Choosing an investment plan that automatically reinvests your dividends and interest is also a way to benefit from the power of compounding.

Evaluate your future
A lot of investing is about how you see your future, financially speaking. We all make certain assumptions while estimating our future needs, and how we intend to meet those needs. But circumstances can change. Hence it is important that you review your portfolio at least once a year. Also try to evaluate the performance of your investments against the level of risk you are assuming for achieving the returns you want. And when necessary re-balance your portfolio to stay on track with your long term financial goals.

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