There is a lot written about how to be a good investor and behaviour that will help you attain long term wealth creation goals. However, even before you step into the realm of investment behaviour, you have to understand the investment product you are buying.
The choice for financial securities has only increased over the years.
From having only real estate to deposits, insurance policies and now market-linked securities, an individual investor is really spoilt for choice. With this choice comes more risk too. There are nuances in products and product structures that need to be filtered through to arrive at the one that’s most suited to your financial well-being.
In other words, you must know the products before investing.
To do this, your first step is to follow this brief list of ‘must know’ for any product you invest in.
1. You must know the cost
Never invest in a product without knowing its cost. While most financial products will have a defined cost that gets charged to the investor, hardly any will display this upfront. Insurance-linked investments, mutual funds and direct equity are all examples of financial products which have a defined cost attached.
In contrast, small savings schemes, public provident fund and fixed deposits are products which don’t have an outright cost attached. You need to ask the seller, distributor or agent who has approached you about the absolute cost and its nature. For many of these, costs are recurring on an annual basis.
Also, keep in mind that cost is not the sole determinant of whether an investment is worth your while or not. There are many things you need to look out for and tickmark for that.
However, being aware of costs is important especially when it comes to choosing between two similar types of investments. It is also important in determining the accurate returns from an opaque investment-linked insurance plan.
2. You must know Risk
Risk can mean many things. Primarily though risk is the probability of losing money when it comes to investments. Market linked investments usually get a bad name as far as risk is concerned because the nature of the investment is such that value fluctuates on a daily basis. However, this risk of short-term price fluctuation does smoothen out over longer periods of time, if you remain invested.
At the same time investments like bank deposits do not come with such daily risks. Hence, if you need money in the next few months or a year or two, it’s best to invest in stable deposits rather than market-linked investments. For long term investments where you don’t need money before 5-10 years, market-linked investments with the potential to deliver compounded returns to beat inflation are perhaps more suitable.
If you leave your long-term money in low yielding bank deposits, then you risk not earning enough to even beat annual inflation.
Whether your investment is market-linked or not, the bigger risk you need to watch out for is quality. If you invest in poor quality deposits or mutual funds or stocks, the risk of losing money is amplified. Do your research and ask the right questions before investing.
3. You must know the return type
We put money in an investment or financial security and expect a return. What is this return, how is it generated and where does it come from? These are some questions that never get asked.
Bank deposits, bonds and debentures give you return as a defined fixed rate which gets paid out also at a defined frequency. A 7% annual return paid semiannually is something we can expect from a bond. It means that if you invest Rs 100, the bond issuer is committed to paying you Rs 7 every year; the payout is broken up into two equal instalments of Rs 3.5 each and paid out twice a year. However, you should know that while returns from corporate bonds and debentures are fixed, they are not guaranteed. The risk of losing your money if the corporate itself faces cash flow trouble can’t be ruled out. Returns from bank fixed deposits are fixed and assured. While public sector banks are backed by the Government, private banks can suffer from failure, although there is deposit insurance that you can rely on in dire cases.
Returns from equity mutual funds and stocks are neither fixed nor assured or guaranteed. They are what we term as volatile.
Before investing you must be clear about the purpose of your investment so that you pick the right type of return. For example, you cannot pick volatile return options where the goal is near completion and the value can’t be compromised.
Similarly, picking guaranteed returns for long term goals can hinder wealth creation.
4. You must know taxation
Taxation is being written about at the end because you must never start thinking about an investment only around its tax incentives or disincentives. An investment has to hold its own as a valuable wealth creator or return generator, then you should consider the tax impact.
However, you should know the difference in how interest-based returns are taxed versus taxation of capital gains. Within that understanding of short-term capital gains tax versus long term capital gains tax is also key. Knowing the tax treatment will help you diversify adequately across a range of products that offer similar returns and it will also guide behaviour on holding period of your investment where you have some flexibility to decide.
Going into an investment without knowledge of the above is like running with a blindfold, but without the thrill attached. Investing money is unlike any other activity you undertake because the outcome is sacred. Give this activity the time and research it deserves. Ask the right questions and gain the relevant information, make sure you the decision on where to invest.