Do you want to start investing? Here is a detailed guide on how to start investing and what are the investment options which you can get started with little money
Investing is a simple process of buying assets that will grow in value over time and give returns. However, it is very confusing to decide where to invest with so many options available. In this article, we have tried to address the issue of how to get started on investing. For beginners, there are three concepts that an investor should be aware of, which are as follows:
Risk Appetite & Risk Tolerance
You, an investor, must identify & assess your ability to take & tolerate risk. Any investment decision that you take without keeping these factors in mind would lead to anxiety & irrational thinking – Let me elaborate further with an example!
Lets imagine you plan to visit a casino and set aside 5000 rupees for your visit. You, in your mind, are okay to “risk” this amount as it may not affect your daily life. On your lucky day, who knows, you could even end up making 50,000 rupees out of that bet! On the day you enter the casino, you win a few games of slots & blackjack initially and your 5000 turns into 6000! At this point you would be happy! Now after a few games, you start losing money and soon you realize that you are only left with 3500 rupees and have “lost” 2500 rupees (technically, you have only lost 1500 rupees). Suddenly, you start wondering whether you should play any longer and decide to take the 2500 loss and go back home.
The 5000 rupees that you were willing to risk is the “risk appetite” you have. However, the 2500 rupees loss at which you decided to go back home is your “risk tolerance”. Your life would not change even if you lose all the 5000 rupees, however, you would start feeling more and more uncomfortable losing any single rupee to a point that you decided to go back home after losing 2500.
Most inexperienced investors end up making investments that do not meet their risk profile and thereby end up dissatisfied with the outcome (returns generated on the investment).
It is aptly said that compounding is the 8th wonder of the world. To understand this, let’s take an example, suppose you invest ₹ 10,000 every year in an asset which gives you 6% returns per annum for the following years:
a. 2 years: You will have ₹ 21,186 that is ₹ 1,186 as returns
b. 5 years: You will have ₹ 59753.1, that is ₹ 9,753 as returns
c. 10 years: You will have ₹ 139716.4, that is ₹ 39,716 return
Similarly, for 20 years, it will give ₹ 1,89,927.3 as returns, and for a person who maintains this discipline method of investing from the age of 20 to 60, it will provide returns of ₹ 12,40,477. The above example demonstrates the magic of compounding, and the equations will change drastically if you buy an asset that gives you higher returns or invests more than ₹ 10,000. The example shows how crucial it is for one to start investing at the earliest; of course, it is better late than never! Another important point to note here is that you’re not withdrawing the interest earned. Rather, you are reinvesting the interest earned over a period of time.
On the contrary, people also make investments so that they can create a stable & passive second source of income. This approach to investing is called “income investing”.
Risk to Returns Ratio
To understand this concept, an individual will realize that assets that offer higher returns will be riskier. Here, the risk does not only mean the default risk but also the risk because of higher volatility. For example, if you compare the returns on government bonds and any blue-chip stock, there is a high chance that returns on a single stock would be much more than the government bonds, but if you look at the daily price data, it can be easily observed that there is a significant change in a single stock on a daily basis. Also, it should be noted that diversification will reduce the risk; one can invest in a different asset. For instance, an individual can keep gold in their portfolio – gold prices & stock markets often move in opposite directions so there is a high chance that gold prices will increase if there is panic in stock market. Long term bonds can also be used for hedging against the high volatility of equity. All asset classes go through a cycle of peaks & lows. As a smart investor, you have to firstly make sure that you are diversifying your investments across multiple asset classes to avoid “concentration risks”. Secondly, you should know how to change the proportion of money allocated across different assets at different market cycles. For e.g., you should put more money in equities after the market crash and more money in fixed income instruments when the market starts to become overvalued. Learn more about the concepts of asset diversification and asset allocation.
To start investing in a disciplined manner, one can follow the following steps:
1. Start Investing Early
Be prepared to put your earnings locked up into investments. Income can be divided into two parts, that is, savings and expenditure. Try to save as much as possible, especially in the early years, because a high amount of investment in the early years will have the most effective results in the long run. Make a rule to dedicate a particular piece of your income to investments, be it 10%, 20% or more. Of course, several personal factors would affect your choices and considerations. For e.g. your choices will be different when you are a college student or an early career professional who is starting out with a small sum of investment versus someone who is already in their 30s. If your goals are to retire early, say by the time you are 40, your investment planning & investment decisions have to be different. Take time to build a sound financial plan for yourself. We have detailed an article on how you could excel in financial planning.
2. Invest time to educate yourself about the investment options; some of them are listed below, along with their resources:
It is a part of the ownership in a company where you can get the shares for some amount, so when a company makes profit/loss, it is distributed among all the shareholders by the management. It is also known as equities. To buy/ sell stocks, commodities or ETF, you need to have the following three things: Bank A/C, Trading A/C, Demat A/C.
When an investor buys shares from the trading account, money is debited from the bank account, and the shares are credited in the Demat account on T+2 day. Some of the famous stockbrokers are Zerodha, Upstox, Motilal Oswal and ICICI Direct. Some of them offer 3 in 1 account to accommodate the requirements mentioned above.
When an individual invest in any mutual fund, it selects a group of stocks on your behalf based on research to diversify the portfolio. It allows an investor to skip the work of stock and bond picking. To decide the mutual fund you should invest in, there are several factors to consider such as it’s performance, expense ratio, exit load. We have exentsively covered how you should go about choosing a mutual fund.
Exchange Traded Funds (ETFs) & Index Funds
These are same as mutual funds as you can buy a group of stocks to reduce the risk through diversification. The only difference being that ETFs can be traded in the secondary market akin to the stocks. The amount needed for the investment is less than mutual funds, thus suitable for newbie investors with a minor income source. Index funds, which are also exchange traded funds, are another good investment option. Major difference between the index fund and mutual funds are that index funds are not “actively” managed. Know more about ETFs and index funds here.
When investing in bonds, you get interest payments and a corpus of money at the maturity date, after years. The government gives these out. Thus, the risk is significantly less. With less risk comes less return, especially in the long run; therefore, it should not be a large part of your portfolio. Applications for the bonds will be received in the nationalized banks and will be issued in electronic form and held in Bond Ledger Accountant.
Bank Fixed Deposits
It can be a good option for investors looking to save tax; it has the least risk but has a lock-in period of 5 years, where early withdrawal is not allowed. Thus this is an illiquid asset; a person should always keep a good amount of liquid assets as an emergency fund. One should keep in mind that the interest rates on fixed deposits are taxable, set off by the amount of tax saved.
PPF & ELSS
Those who are looking to save tax can invest in PPF. Public Provident Fund (PPF) is a very risk-averse option; it suits those investors who want to avoid volatility in returns akin to equity. However, for long-term goals and especially when the inflation-adjusted target amount is high, it is better to take equity exposure, preferably through equity mutual funds like tax-saving ELSS. These can serve as a good option for long term goals such as retirement.
National Pension Scheme
NPS is a scheme started by government that aims at ensuring stable life post retirement. It is a long term investment instrument and offers a lot of flexibility in terms of how your money should be invested within the different NPS alternatives. One of the major drawback of NPS is the lack of liquidity & investment lockins at the start of investment duration. We have covered the details highlighting pros and cons of NPS.
Remember there would always be multiple choices to choose from at every point of your investing life. Not all investment options are relevant to everyone. Some choices such as equity investments & mutual funds are more suitable when you are younger and have fewer responsibilities whereas other type of investments such as fixed deposits, secured bonds, etc. are more suitable as you grow older and need more stability and predictability in your income. Another factor that impacts the choices of investment is personal situation and importance an investor places on liquidity. For example, real estate may be a very stable long term investment but the liquidity is extremely low as the prices of the real estate investment go up. On the contrary, stocks are very liquid (in most cases), however they come with much higher volatility in prices. At the end of the day, every investor should focus on finding the right balance of risk and returns & volatlity & liquidity for the investments choices they make.