Monday, June 14, 2010

Key Principles for Long-Term Wealth Creation

By

Vikram Kotak, Chief Investment Officer, Birla Sun Life Insurance

 

The journey of life is full of aspirations and goals. And, to fulfill these, we need to ensure we have the right resources built over a period of time. And, in order to create these resources, it is important to begin investing at the right time, in the right asset class, in the right proportion and do the right amount of rebalancing.

 

Let’s look at some of the key principles one must keep in mind in order to meet life’s financial goals in a systematic manner :

 

1.      Start early and invest regularly:

Regular investments, however small, can grow into a substantial amount of wealth over time. Longer investment tenure will allow you to enjoy the effect of compounding. For instance, A (20 years old) and B (30 years old) start investing Rs.1000 & Rs.1500 p.a. respectively. By the age of 50, both would have invested the same amount, i.e., Rs 30000. However, assuming 10% return on investments, A would have accumulated around Rs.181000 while B would have only Rs.95000, nearly half the amount! This is the magic of compounding. B would have to invest Rs.2850 p.a., 2.8 times that of A, to get Rs.180000 at the age of 50.

 

2.      Have a clear objective:

It is of paramount importance to think about your long-term financial goals before you start investing. This will have a bearing on the nature of investments & asset allocation. You should know whether your investment objective is liquidity, capital protection, stable returns or capital appreciation. For instance, the objective of a person nearing his retirement would be to ensure a regular income and capital preservation while that of a young professional will be to achieve capital appreciation to buy a house.

 

3.      Understand & analyze your risk appetite;

“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”- Warren Buffet. Investing too conservatively or too aggressively, without paying heed to your risk profile, can result in failure in meeting your investment objectives. Different asset classes have different degree of risk & returns associated with them. Equities have the potential to deliver higher returns than fixed-income instruments but also have higher risk compared to the latter. You should invest in asset classes that have the potential to generate returns which are adequate to meet your financial goals at the desired level of risk. Few factors that impact risk appetite are life stage, net worth, income and past investment experience. For instance, an individual who is young and has more disposable income and less financial obligations may opt to invest in assets with higher risks and follow an aggressive investment strategy.

 

4.      Invest with a long-term perspective

“If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes”- Warren Buffet.  In the short-run, markets can be very volatile and such market uncertainty can be an unnerving experience. Investments should be made with long-term perspective as over the long-term market volatilities withers out. Despite witnessing periods of negative returns, Sensex has delivered a phenomenal CAGR of 16.8% over the last two decades!

 

5.      Do not try to time the market

Always remember the old adage “Predicting rain doesn't count; building arks does”. Timing the market is a futile exercise and one can seldom hope to get it right. Research has shown that following a long-term disciplined investment approach and remaining invested even during uncertain times has seen investors reap the true benefits of any financial investment.

 

6.      Adequately diversify - Do not put all your eggs in one basket

“Controlling risk is the key to long-term rewards and controlling risk means being diversified at all times”- Jim Cramer.  By diversifying you will not have to rely on the success of just one investment and you will be able to confidently ride the markets’ ups and downs.

 

7.      Stick to Quality. Do not chase trends

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”–Warren Buffet. It is important to be invested in inherently good quality fundamentally strong companies with sustainable and scalable business model, visionary management with proven track record and bright prospects.

 

8.      Do not panic

“Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”- Warren Buffet. In a bear market do not panic and rush to sell your investments. Be patient. Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it. Always remember that equity markets are bound to go through cycles, however, equites have been the best performing asset class over long-term.

 

9.      Monitor your investments

As you move from one life stage to another, your investment objectives may change. It is important to assess your financial investments in light of your changing needs. The 'Lifecycle’ theory of investing ensures that the risk profile of an individual’s financial investments stays in line with his reducing risk appetite as he moves from one age band to another. It calls for investment portfolios that invest a decreasing proportion of assets in equities and a greater proportion in fixed-return instruments as the individual moves from one age band to another. One should not frequently change the asset allocation based on market conditions.

 

10. Learn from your mistakes

What we learn from history is that people do not learn from history.”- Warren Buffet. Do not try to recoup your losses by taking bigger risks. Turn each mistake into a learning experience.

 

11. Do your homework well or hire professional experts to help you

“Risk comes from not knowing what you're doing”- Warren Buffet. It is very important to deeply analyse any financial investments and fully understand its risk-return profile before investing. It requires time and efforts along with relevant skill sets. If you do not have the adequate resources or the expertise to do it then leave it to professional experts.

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