Factors a first time investor must think about before investing
Factors a first time investor must think about before investing
Rules of thumb may come in handy for those who are just beginning their financial planning. Youngsters who have just started their career may get some direction on where and how to make a beginning. For those who are in the middle of their career and don’t yet have a proper plan in place, thumb rules can also be helpful. But remember, they only provide a general direction and may not necessarily give you the exact picture.
First rule first
The very first rule of personal finance says: ‘Pay yourself first’. It simply means that out of your monthly income, a certain percentage has to be saved before it is spent. ‘Income minus savings equal to expenses’ should be the rule and not vice-versa.
For this to happen properly, identify your goals, estimate the inflation-adjusted requirement and then find out how much you need to save for them. Now make sure that each month funds move out from your salary towards your goals, and manage your household expenses with what is left. You, in a way, are first paying for yourself, i.e., your goals.
How much to save
As a rule, 10 per cent of the post-tax income of those starting their career at around age 25 can be the starting point. Over time, as the income increases, shoring it up to 15 per cent can give you a good head start and a buffer. As you grow older, and your income rises and financial liabilities add up, make sure you are saving enough towards your goals. In middle age, saving at least 35 per cent of your post-tax income should be the benchmark, as expenses during this period typically increase.
The 50-20-30 Rule
Confused about how much to save and spend each month? Here’s how to get started. It’s the 50-20-30 Rule, i.e., 50 per cent of your income should go towards living expenses, i.e., household expenses, including groceries; 20 per cent towards savings for your short, medium, long-term goals; and 30 per cent towards spending, including outing, food and travel. The idea is to create outflow buckets for better control. Individuals may tweak the percentage according to their age, circumstances, etc.
The 20/4/10 Rule
This rule helps keep your finances under control when you’re buying a new car. Twenty stands for the down payment amount, as 20 per cent of the car price should be paid by you. It’s, however, better to make as much down payment as possible. Four stands for the number of years of financing. Although lenders have a tenure of up to 7 years, it’s better to stick to 4 years. Ten stands for the ideal percentage of your net-take home salary that should go towards car loan EMIs.
As the name suggests, an emergency can happen anytime and needs immediate action. There could be a setback to one’s earning capacity due to a temporary disability or being unemployed for a few months. A medical emergency may crop up at a time when the settlement claim is taking time, or the ailment itself may have a waiting period. In such cases, one may have to arrange for funds to tide over the situation. Whether it’s meeting the household expenses or honouring commitment towards EMIs, certain cash outflows are sacrosanct. An emergency fund is not aimed at meeting your planned goals, but it only acts as a safety net.
Although there’s no fixed rule on how much emergency cash one would need, ideally 3-6 months’ household expenses should be one’s emergency fund. The amount should help you to combat financial emergencies.
You should ideally have a life cover which is at least 10 times of your annual income. The actual requirement may, however, depend on one’s age, goals to be achieved, financial dependents, accumulated wealth, etc.
The most cost-effective way of buying life insurance is through a pure term insurance plan. It is a low premium, high-cover protection plan where the premium goes entirely towards risk coverage, i.e., to cover the mortality risk. Therefore, on surviving the term, one doesn’t get anything back as there is no savings portion of the premium. But that should not deter someone from buying a term plan as risk cover through life insurance as it is one of the basic necessities in one’s overall financial plan.
How much to save for retirement
Most financial planners suggest a retirement corpus target which is about 20 times of one’s annual income. Some feel that 30 times can be a better figure as it will take care of inflation. It gives you a reason to work backwards and estimate how much you need to save from today till you retire.
Still, this rule may leave you disappointed as it takes income and not expenses into account. Also, it may work for those whose retirement is years away than those who are retiring soon.
By keeping three things into consideration, i.e., the take-home income, the down payment amount and the home loan interest rate, one can figure out the worth of the house that one can afford to buy. If one is buying a home with a down payment of 20 per cent and the rest on a home loan, and also keeping the income-to-EMI ratio in mind, the affordability arrives at about 4.5 to 5 times of one’s annual income. In other words, one is buying a house which costs about five times of his income. Therefore, when real estate prices go up, affordability becomes a concern, unless income also moves in tandem.
When it comes to mutual fund schemes, investors are known to hold a many as 30 different ones. Over-diversification may not necessarily help in obtaining the right result for the portfolio. J.L. Evans and S.H. Archer have shown in their research that most diversification benefits are obtained with about 10 funds. Adding more funds still provides benefits, but the gains seem marginal compared to the drawbacks of managing the enlarged portfolio.
Best use of your money
Making the best use of your money is the golden rule to remain financially stable. It becomes important to determine whether investment is the most appropriate use of your money. For instance, you may assume that you have money available for investment, when in reality you may have a huge outstanding credit card bill to pay. If the interest payable on your outstanding credit card amount is higher than the return received on your investment, you are bound to suffer a financial loss. In such a situation, it is wise to repay your debt on priority basis and consider investing later.
Another way of preventing financial damage is by purchasing an insurance policy before investing. An insurance policy offers the much-needed risk coverage in case of an unfortunate event. You, therefore, need not deplete your lifetime savings or wipe out all your existing investments. A recommended option is purchasing a mediclaim policy, one that offers protection from hospitalization expenses during medical contingencies. You may also consider investing in a term plan. This pure risk cover offers financial security to your loved ones in case of an unfortunate event of death.
For protection from emergencies, such as loss of job, you may consider building an emergency cushion fund of around three to six months of salary. This money may be invested in an instrument that offers immediate liquidity, such as a high-interest savings account, or money market funds. In case of an emergency, you may cash out the amount and finance your obligations easily.
Reason for investing
To decide where to invest your money, it is important to identify the objective of investing. Some wish to preserve their capital and, therefore, take on low risks. Other investors seek to multiply their gains quickly and are willing to take on higher risks. Following are the investment strategies you may deploy for achieving your goals.
Take aggressive risks for higher profits
If you are willing to take risks with your money with an objective to gain a higher return on investment, then growth should be your financial goal. To achieve this, you may invest in stocks and mutual funds on a long-term basis.
Take a moderate risk for moderate appreciation
In case you do not need to fulfil any of your financial goals in near future, you may take on a little risk with your money. A wise choice would be to opt for investments that offer moderate appreciation with well-balanced risks, such as balanced funds.
Be risk-averse if you need your money soon
In an event that your financial goal is in the near future, such as your retirement age, you may invest in less-risky instruments like bonds. Investments in these instruments ensure that the capital amount is safe and does not decrease in value.
How old you are has a great impact on the choice of investments. If you have age on your side, you have a higher risk-taking ability as you may not have much responsibilities. Additionally, you have a longer time to recover from losses if the financial market fails to perform. Besides, starting early allows you to enjoy the power of compound interest. You may earn interest on your interest as well as the principal amount, allowing your money to grow significantly. As you grow older, your responsibilities increase and you may opt for investments that are not highly prone to risk.
Ability to take on risk
It is common knowledge that higher the risk, the greater is the potential return. You may assess the level of risk that you are willing to take before making an investment decision. Once you have ascertained your risk-taking ability, you may make a choice from a wide variety of options. For example, if you are a risk-averse individual, you may opt for fixed deposits. Alternatively, equity investments would be an ideal choice if you wish to take on greater risks.
You may choose the most appropriate investment product based on your available time horizon. If you have a financial goal with a greater time horizon, you may take on more risk and earn higher returns. In case you have short-term financial goals, the principal aim would be to invest in an avenue that does not put your money at risk and which can be converted to cash easily.
With various types of investment choices available today, choosing the best one may be an overwhelming task. You may take the aforementioned factors into consideration and make a well-informed investment decision.
There’s no ‘one size fits all’ approach. Your finances need to be personalised according to your risk profile, situations, etc. Once you have made a start using the thumb rule, it is important to review things over time and make any changes to your plan accordingly.
Dilzer Consultants Pvt Ltd