Saturday, May 9, 2009

Basics of Getting Started with Stock Market Investment

Set Your Objectives

The starting point for achieving financial independence begins with a financial plan. Determine your current financial position, available resources and immediate fund requirements. Then set your long term financial goals: keep in mind your risk-taking ability, current lifestyle, occupational profile and family background. The number of dependents and their own financial status –a working spouse gives you a greater degree of financial freedom- should also be considered.

A financial plan helps an investor to lay out realistic goals and then work towards them over a period of time. Since each individual has a unique setup, this section only makes broad recommendations that should apply to everyone before embarking upon an investment programme.

Estimate short term needs

Many investors plunge into the stock market without assessing their short term fund needs. Faced with a crunch, they end up selling shares much earlier or book losses at the smallest sign of trouble. That clashes with the fact that the holding period in equities is crucial to meet the targeted return. By estimating short term needs and preparing for them, the painful decision of selling shares before time can be avoided.

Create an emergency fund

Emergencies happen when least expected, forcing you to alter your investment plan. Therefore, having a cash reserve to help meet situations like a medical emergency or a layoff, ensure that your fund requirements are met without affecting the investment plan. A cash reserve (money market funds, which can be easily converted into cash should do) of at least six months worth of living expenses or a medical or disability insurance is a must.

Repay debt

Increase your net worth by repaying debt. Start by repaying the most expensive debt – usually credit card debts and unsecured personal loans are the most expensive. Keep some amount of debt, especially if you get a tax benefit, like on housing loans. If the return on investment is greater than the amount of interest paid on debt, invest. But if the risk-adjusted return is still less than the amount of interest being paid on the loan, you are obviously better off clearing the loan.

Set priorities in a chronological order

Classify your own priorities and that of your family members based on their time of occurrence. For instance, paying a lump sum donation for getting admission to school is a more immediate need, than providing for higher education. College education is still years away compared to school. Thus, school education can be provided for by investing in fixed income instruments like short term bonds or fixed maturity plans of mutual funds. For college education, a mix of equity and debt, with more in equity, can be taken to combat inflation and the higher risk is spread across a number of years.

Practice Asset Allocation

No investment plan is complete without an asset allocation. Different types of assets exist; the most common ones are cash and bullion, the most liquid asset class. Then, there are fixed income instruments, like bonds and fixed deposits, which are less risky, but yield lower returns compared to equities, and are less liquid too. Mutual funds come next, their risk profile depends on the type of fund –equity or debt or balanced and the investment philosophy. Sector-focused funds, for example, will be less riskier compared to diversified funds. Equities are the most aggressive investment option, with high returns and commensurate risk too.

Since there are various levels of risk associated with various assets, it makes sense to identify your own risk-return profile and then build an asset allocation strategy. There is no ideal asset allocation, a one size fits all plan. You have to make a plan that suits you best, allocating weights to various asset classes and then designing an investment plan accordingly.

After designing an asset plan, it is imperative to monitor it to ensure that changes in asset prices have not skewed your allocation. A sharp rise in equities, for example, may increase your exposure to equities, much more than you may want. So, selling down equities and increasing exposure to debt would be the right thing to do.

1 comment:

Anonymous said...

Nice post.

Following are broad, easy to understand general money thumb rules you could use as a starting point for assessing what to do in your own financial situation. This are not universal laws, so applicability may vary from person, place & situation.

Savings - As a rule of thumb you should be saving at least 10% of your annual income. The earlier you start saving, more time your money would have to grow with the help of power of compounding. Early you start saving, the early you would be able to retire.

Emergency Fund - Keep six months of your gross monthly expenses in savings account for emergencies. If you have a single source of income or have more dependents you may need to keep more in emergency fund.

Retirement Fund - You should have retirement capital fund which is 20-25 times the annual income you would need at retirement in future. Also take into account your lifestyle & inflation.

Home Finance - Spend no more than 2.5 times your gross income on a home. Come up with at least 20% of down payment.

Stocks Portfolio - Subtract your age from 100 for percentage of your savings that should be in stocks. If you're investing for the long-term(10 years+), stocks are the place to be. As you get older, you should gradually move money out of stocks and into fixed income debt. Invest no more than 10% of your portfolio in single stock.

Life Insurance - You need life insurance that can replace at least 5 times of your annual income. This way surviving family members would have enough time & money to adjust financially. Also stay at home spouse (usually wife) should also have life insurance, as they are home maker, the same services cost money if done by others in there absence.

Shopping - Resist the urge to buy latest gadgets mobiles,cameras,audio-video system,cars/bikes or any consumer good which is not a need and only a want. Most of this goods cost most when launched. Wait for 6-12 months, you are mostly likely to get it substantially cheaper, the product would still serve your need for next many years.