What is your purpose in investing? Are you saving for a short-term goal like buying a car or for long-term goal like retirement plan? How comfortable are you with taking risks? Answering these questions is important to prepare the correct plan for your finances. Unfortunately, not many spend time answering these questions.
We all have various aspirations in life. Whether it involves buying a new house, going on a trip around the world or sending your children to Harvard, taking a look at your finances is the first step towards achieving your goal. To achieve any goal successfully, proper financial planning is very important. Unfortunately many people ignore this step, and so fail to reach their goals. A financial plan is the path that leads you to your goal. Sticking to this path will help you ensure you reach your goals successfully. Hence it is essential for everyone to plan their finances as soon as possible.
The steps to plan your finances: While many people invest their money, they do so without any goal in mind. As a result, they tend to invest based on the ‘hot tips’ given by their friends and brokers. They invest in NFOs or aggressive funds like sector funds in order to earn higher returns, though these funds are incapable of helping them reach their goal. This is what leads to failure in achieving their goal. To plan finances successfully, you should be aware of the following factors:
a. Risk vs Returns: The first thing that you should remember as an investor is that there is a direct relationship between risk and return. Higher the risk, higher the returns and vice versa. If you are looking for very high returns, you will have to face the risk of capital loss. Unfortunately, many people ignore this fact when they invest and focus solely on the risk. So when the situation changes and these investments lose their value, these people panic and sell off their holdings thereby worsening their loss. While risky investments like equities do have their place in the financial plan of the investors, they must be used specifically for achieving long term goals like retirement planning. For short-term goals like purchasing a car or taking a trip, it is advisable to opt for low risk investment options.
Sonia was looking forward to marrying her long-term boyfriend within 2 years. She wanted to start saving towards the marriage expenses. She opted for equity mutual fund, lured by the high returns it generated. But when the market crash came, she found the value of her investment had fallen by more than 50%. Where did Sonia err? Well she chose a risky investment option like equity mutual fund for a short-term (2 years) goal. While equities are an excellent vehicle to build wealth, they are risky over a short period. Instead Sonia should have focused on investing her money in debt products like FDs or money market funds.
b. Understand Yourself: What is your purpose in investing? Are you saving for a short-term goal like buying a car or for long-term goal like retirement plan? How comfortable are you with taking risks? Answering these questions is important to prepare the correct plan for your finances. Unfortunately, not many spend time answering these questions.
Prateek was advised by his financial planner to start his retirement plan. The adviser recommended a couple of sector funds that he claimed would help Prateek build a substantial nest egg. As Prateek was just 27 years, he readily accepted the recommendations. But during the market crash of 2007-2008, he found his investment value had crashed substantially. As a result, Prateek panicked and stopped further investments. Not only that, he sold off his investments thereby suffering heavy losses. What was Prateek’s mistake? For one, he did not spend time understanding himself. He did not devote time to find out how sector funds work and their risks. Remember sector funds are very volatile. While they do well in short-term, over the long-term you can end up losing money. As retirement planning is a long-term goal, these funds were totally inappropriate for his needs. Instead he should have opted for diversified equity funds that are less risky but can generate high returns over the long term.
c. Diversify your investments: One of the key mistakes most investors make is to focus on investing only in the investment options that are ‘hot’. They ignore the other options that are not much in demand. However they don’t realize that all asset classes have their cycles. Whatever is hot today, goes out of favor after some time. This is when their investment loses in value. Hence in order to protect this downturn, it is essential for all the investors to diversify their investments.
Sunil was young, yuppie executive. He had dreams of becoming rich. He earned a monthly pay of Rs. 50,000. With the stock markets zooming sky high, he put all the savings into stocks, with a very high concentration on small and mid-caps. But with the recent market crash, Sunil lost all his money. Besides most of his stocks turned illiquid as they were small and mid-caps. Sunil was left totally broke. The main reason for Sunil’s problem was his excess focus on stocks, particularly small and mid-caps. In short-term, stocks can be very volatile, making you lose all your capital. Besides mid and small-cap stocks are potentially rewarding but also extremely risky. They can turn illiquid very soon. Hence it is important not to put all your eggs in on basket. Had Sunil divided his savings amongst debt, gold, realty and stocks, he would have saved himself.
d. Insure yourself: Simply investing is enough. It is also important to ensure that this investment is fully protected against any unforeseen events like death, loss of employment, accidents, or even natural disasters like floods, earthquakes etc. These types of disasters can end up destroying the total worth of the investments. Hence it is essential for every investor to take adequate insurance to protect their investments.
Prachi was saving money to buy a car. She had long dreamt of owning a Mercedes. But suddenly one fine day, she met with a severe accident. As a result she had to stop working. Since she had started working for just 3 months before the accident, he employer did not pay her for her absence from work. To pay for her medical expenses, Prachi had to liquidate her savings, since she did not have the suitable medical insurance. So the moral of the story: Insure yourself.
To achieve any objective, every investor must plan his finances in line with his goal, risk appetite and time horizon to reach the goal. Selecting suitable investment options will help the investors reach their financial goals without any pitfalls.
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