Advice On Understanding The Basics Of Investing

by skorg

posted on 05/11/2009

One thing that I hate doing is advising others. Many don't understand that the final decision is their own and end up blaming others for the advice they got from them. But 'Personal Finance' is more of a hobby to me and so I decided to pen down a few things here. But I highly recommend those who read this to first do a personal survey before committing to any decision (and later blaming me). Also note that the examples given below especially the percentages may vary in your location.

Let us first try to understand a few things. We all know that Investing is to put our money to work for us. There are many places we can do that. Let's say we put $1,000 in our savings account in a bank. After one year you will get $35 as interest and so the total is $1,035. Pretty Good!

But wait, there is another factor called inflation. Now what is that? It is the purchasing power of your money. Today, for $1,000 you are able to buy a few things, but with a price rise (inflation) you will not be able to buy them in the future for the same amount of money. (We hear from our parents that they were able to run the monthly budget with just $xx.) Your money shrinks in value and that sometimes is by as much as 8% in a year. So your $1,000 is worth only $920 (though you will still have $1,000 in hand) at the end of the year and add to that your $35 giving you only $955. Pretty Bad, right? The 3.5% we get in a savings account is called an annual return. Of course almost every saving instrument gives compounded returns. (Interest from the first year will also earn interest in the next year and so on).

Now we will speak of the risk-return-liquidity ratio. The higher the return, more likely higher the risk involved and/or lesser the liquidity (Liquidity refers to how quickly you can get your money). For example, your savings account is the safest and naturally has the poorest return. But it also offers the highest liquidity (Go to an ATM and get the money, as simple as that). Consider fixed deposits in banks, the risk again almost nil, the return is better than savings (around 5-6%), but the liquidity is compromised. (You need to wait until the fixed deposit term ends). Coming to the stock market, the risk is very high, but the returns can be phenomenal (12% and above, can even go to 100% or more) and the liquidity is normal (You need to sell your shares).

We saw the risk-return-liquidity with respect to the various saving instruments. But there is another part to it: the risk tolerance and the liquidity need of the individual. (Simply put, why are you investing?) A person in his 20's may be willing to take more risk with his investments than a person in his 50's. Also two persons of the same age may be totally different with respect to risk tolerance. One may be married and with kids, while another may be saving for his marriage. Also an individual can perceive risk differently. For some, a loss of $10,000 may not be a loss at all, while some others can not even think of losing a dollar (I am not talking about the rich and poor but of the mentality). That is why I put a disclaimer at the top. Each of us is so different that one is better off not advising others. Similarly liquidity needs (aka "time horizons") might differ. Some might be investing to buy a fancy car within the next 2 yrs, while some might be investing for retirement.

The magic called 'Compounding'. When your interests start earning for themselves, the ripple effect is so high that even 'Einstein' was shocked. To understand that let us take two guys. One, Mr. A, started saving $500 per month when he was just 25 and continued until he was 50. Another, Mr. B, started a bit late when he was 35 but saved twice as much as Mr. A did i.e. $1000 per month until he was 50. When they were both 50, Mr. A had $1,276,758 while Mr. B had $570,965. Not Even Half! But why? What did Mr. B do wrong? He started late...Once I saw this written on a hospital van - 'Time is Life' in a Heart Attack. Remember this 'Time is Money' in investing. When you hear a tremendous amount being forecast in an investment, it is 99.99% due to compounding only.

I will discuss a few more topics in detail in the other lessons, but thought it better to put down a few words of relevance here.

'Investing is not gambling' - If you think so, stop here and please visit a casino.

'Investing is not tax planning' - Very important topic, will be discussed in greater detail in the upcoming lessons.

I have started this string of lessons. If you find them useful I will continue
1. Understanding The Basics Of The Stock Market - http://www.advice.com/latest/article/2009/04/16/Advice+on+Understanding+the+Basics+of+The+Stock+Market

2. Advice on Understanding the Basics of Investing - this article.

More to come

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