Personal Finance Ideas

Types of Investments or Asset Types - I

One of the things to understand before starting putting money into anything is to understand the type of the investment vehicle.

Currently, there are multiple types of investment options available to people. The main thing to note is that each type of investment has a particular level of risk and an expected rate of return. As mentioned in my last post, the more the risk, you should expect higher returns.

Let us spend sometime on some of the most common investment classes available:

Bank Savings Account 

This is something everyone most probably has(If you are reading this, then you surely have one:) ). In almost all countries, this is very safe, as mostly these are secured by some kind of a national insurance program. (FDIC in the US, DICGC in India. You can find more information on Deposit Insurance in other countries here).  So the overall risk is very low and so is the return. For example the max return you can find for an online savings account in the US is around 2.6% now (Most of the bigger banks will give you even less, like BOA’s savings rate is a nearly nil 0.20%). Similarly in India, you are looking at around 3.5% on your savings account. So with an inflation rate around 6+% in India, you are actually loosing money in your savings account.

Liquidity : High; Returns : Low; Safety : High

CD or Fixed Deposits

These are accounts where you commit to keep a fixed amount with the bank for a predefined period. As the liquidity is less and you also commit to keeping the money with the bank for a fixed time, the returns are usually higher. Usually the interest rate increases over the time of deposit for a range and then start to plateau or even decrease. For example, in the current scenario in India, you will find that the rate increases till around a 1 year term and then actually drops .5% before being constant after that. This is because, the banks think that interest rates will come down over that period of time. The rate offered is usually a reflection of the general interest rate scenario as well as the particular banks need for capital.

Liquidity : Low; Returns : Medium; Safety : High

Real Estate

One of the most common investments all of us make is in a house. Though this is a investment in real estate, most of us do not see this as an investment, but rather as a need. To an extent this is true. For example in the recent housing problem in the US, quite a lot of people continue to stay in their homes even though it is now worth less than what they paid for it because they feel an emotional attachment to it. It is also possible for you buy multiple houses, offices as investments or invest via a REIT (Real Estate Investment Trust, this is something that is common in the US, but is just making an appearance in India). The problem with owning real estate is that it is very ill-liquid and also requires high investments. Also the returns are tied to market movements, though over a really long term (10+ years) real estate prices always go up

Liquidity : Low; Returns : Medium; Safety : Medium

Precious Metals (Gold/Silver/Platinum/Palladium)

Mostly people consider this as part of commodities, but I prefer to see this as a separate asset type as there are some special considerations here, esp in the Indian context of owning jewelry.

Most people own precious metals as jewelry. India is especially know for its affinity to gold. Though your jewelry is an investment in some sense, it is usually not the best as there are a number of unwanted costs that are loaded into jewelry (the cost of wastages and other making charges) and the metal is not always 100% pure. So if you want to invest in precious metals, then do so as bars or coins. Also having it as bars or coins may increase liquidity and selling price in certain cases.

Most precious metals have relatively stable and slow price increases as most of the production is well controlled by global consortiums. That does not mean that the price of gold will not rocket up or down (like last two year when it went up nearly 20%), but rather that over a period of time your average growth is going to mostly constant. Do note, there is the risk of holding a large quantity of gold due to theft etc. Nowadays you do have the option to invest in Gold via the so called Gold ETFs (Exchange Traded Funds), which allow you to hold Gold without actually having the metal with you (for a small fee of course). So this allows you to increase the liquidity and reduce risk of theft etc.

Liquidity : Low; Returns : Medium; Safety : Medium-High

Technorati Tags: Personal Finance,Asset Types

Liquidity

Another thing you need to analyze before you invest is around Liquidity. Liquidity analyses how long will it take for you to convert your investment to cash without major loss of value. Again like with Risk, the most liquid of investments usually do not have a very high return. But the relationship between liquidity and return is not as clear as with risk. For example, real estate is a very illiquid asset, but this year, it has had very bad returns. Similarly, Gold is an relatively illiquid asset, but has had decent return this year.

But it is important for you to understand liquidity as putting all your free cash into a very illiquid asset can actually erase all your investment, when there is some kind of emergency.

Risk vs Returns

We have discussed about Inflation, which is a very important part of building Wealth. The other important thing to consider is Risk.

Risk basically measures the probability of you losing your money/capital. Why do you need to understand Risk to invest? Because, everything about investment/building wealth revolves around risk. Higher the risk, higher the returns on your investments. As you are taking more risk, you get paid more, either as interest or dividends or price of your investment etc.

There is not clear measure of Risk. It is more of a approximate measure and that is why I mentioned it is a probability. You may still loose money in a low risk investment, but the probability of that happening is very low.

Also not everyone is able to handle the same amount of risk. So it is important that you understand how much risk you are ready to take and plan your investment strategy accordingly. If you want to take low risk, be ready to accept lower returns. If you want to get 20% returns, then be ready to take the kind of risks that involves. One of the things that has happened recently in India is the wide spread availability of Mutual Funds and ULIP policies which are purchased by people without any idea of the risk that entails. A lot of the selling of these investments are via agents who work on commission basis and so do not explain the kind of risks involved to the investor. This can lead to shocks to the investor when he looses a large part of the capital during a downturn (as is currently happening around the world).

Your risk appetite is dependent on a number of factors. Some of these are:

• Personality
• Age - The older you are the less risk you should take
• Investment Expectations - If you expect higher returns, you may be ready to take more risk
• Investment Timeframe - If you have a longer timeframe for the investment you may be able to take more risk, as you have more time to make up for losses
• Income and Wealth - Historical data shows that higher income or wealth the more risk you may be ready to take

A number of financial planners have a questionnaire that will help you identify your risk profile. There are also a couple of portfolio or brokerages that provide a risk profile option to their clients. It is very important that you identify what your risk profile is as it will directly impact the decisions you will take about your portfolio, which will affect the growth of your wealth.

The basic rule of investment is more the risk of the investment the more the returns. For example, Fixed Deposits are considered quite safe. But even in those there may be difference in rates between a public bank, private bank or a private company. Obviously the risk rises as we move from public bank to a private company and that you will see reflected in the interest rates. Also this may not be the actual risk, but rather the perceived risk. For example, there may not be no major difference in risk between a public or a private bank, but if investors see one of them as less safe, they would bring their money in only if the return matches their perception.

Risk is an integral part of investing and recognizing that is the first step toward successful investing.

Inflation and Wealth Building

Conventional wisdom says, you build wealth by saving. Let us take a scenario, you decide to save Rs.100 every month for 1 year. So say you put Rs.100 into a safe place every month for 1 year.

Mathematically, you will be Rs. 1200 richer by the end of the year. That is if there is no inflation. But in the real world, you will have Rs.1200, but it will be worth a lot less. Say you have an annual inflation of 8%, your Rs.1200 is just worth, Rs. 1104. This can be confusing. You will have 12, Rs.100 notes in hand (at the end of the year), but it will actually purchase what Rs.1104 can purchase now. That is what makes inflation so hard to understand or visualize.

By definition, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Basically the value of money decreases over time due to inflation. There are a multitude of factors that may affect inflation or price rise, including supply/demand, credit availability etc. Since we now use notional currencies it is even more prevalent and dangerous for a wealth builder. Inflation is not bad, it is an indicator of growth. It is when inflation becomes very high that we start getting into problems. Negative inflation or deflation is a indicator of a weak or non-growing economy. So most central banks try to maintain inflation in a range that they think are suitable for that country (e.g. the reserve bank has a range of 4-6% as their target for inflation in India). Mostly emerging economies have a higher inflation than developed economies, as they are growing faster.

Inflation also has an direct impact on the interest rates that a bank will provide. In most cases interest rates for savings accounts are usually lower than and rates on Fixed Deposits/CDs may at least break even or be a little higher than the prevalent inflation. Central banks also use interest rates to contain inflation. Higher the interest rate, less money gets borrowed, so less products are purchased and so less the inflation.

So from a wealth building perspective, if you are to retain the wealth you have, you still need to at least beat inflation. So for you to have Rs.1200 (or rather the ability to purchase goods worth 1200 now after 1 year) in 1years time, you will actually have to save Rs.1296 (assuming the same 8% annual inflation).

So when you put money into a saving account that gives you 5% returns when your annual inflation is 8% is actually a money losing effort rather than saving. In this scenario, your actual interest rate is a negative 3%.

In 2008, inflation went as high as 13% in mid August and at the end of the year has decreased to around 6% due to slowing economic growth. India's average inflation (based on WPI, all commodities) over the past 12 years (till 2007) has been around 5.2%. You can use an average rate like this to plan your savings for the future. Assuming that this average inflation figure remains the same over the next 12 years, your money will have to earn a return of atleast 5.2% to be from losing its value.

The current savings account bank interest rate in India is around 3.5%. Thus any money you have in the savings account is losing money at the rate of almost 1.7% a year based on 12 year average inflation. Thus your savings account is actually a negative growth account.

This is one of the main reason that people find it difficult to build wealth, because they do not plan for inflation.

There is a very simple inflation calculator available here, that you can use to see how much you need to save to have x amount in a few years time.

Money Basics - Currency

If you want to build wealth, you need to understand some money basics. Our day to day interaction with money is in the form of currency notes,  rupees, dollar etc.

Initially when man started the process of trading, it was based on barter. Overtime it was found that barter was not very good. It had a number of problems,

1. There was not standard way to arrive at relative value of things for barter
2. It becomes a problem if people do not want what you have for barter.

So thus was born the idea of a common standard way to pay for stuff, ie. money. Many things have been used as money starting from sea shells to printed paper that we use today. But till very recently, money was still based on a commodity (a physical entity). The most commonly used commodity was some type of precious metal, gold or silver. Till very recently the world actually used what is called as the Gold Standard. That meant that you could take your currency to the central bank and they will give you the equivalent in gold. So gold was the currency, but instead of bartering gold, you exchanged notes that represented the physical gold. So a country could only print the amount of currency based on the amount of gold the country has.

A pure gold standard was used between the 1879 and 1914 by many modern trading nations. Under the gold standard system, all participating currencies were convertible based on its gold value. For example, if currency x was equal to 100 grains of gold, and currency y was equal to 50 grains of gold, then 1 x was equal to 2 y.

Because currencies were convertible in gold, then nations could ship gold among themselves to adjust their "balance of payments." In theory, all nations should have an optimal balance of payments of zero, i.e. they should not have either a trade deficit or trade surplus. For example, in a bilateral trade relationship between Australia and Brazil, if Brazil had a trade deficit with Australia, then Brazil could pay Australia gold. Now that Australia had more gold, it could issue more paper money since it now had a greater supply of gold to support new bills. With an increase of paper bills in the Australian economy, inflation, i.e. a rise in prices due to an overabundance of money, would occur. The rise in prices would subsequently lead to a drop in exports, because Brazil would not want to buy the more expensive Australian goods. Subsequently, Australia would then return to a zero balance of payments because its trade surplus would disappear. Likewise, when gold leaves Brazil, the price of its goods should decline, making them more attractive for Australia. As a result, Brazil would experience an increase in exports until its balance of payments reached zero

The gold standard basically ended around 1971. So the money you use is actually not backed by any commodity. It is based on the backing of the government of the country that printed that currency. The US Dollar is the most trusted currency and is held as the backing by most countries. Most countries also hold large amounts of gold as hedge against the dollar and also to have an alternate backing for their currency.

This is usually called Notional Currency or Fiat Currency.

The terms fiat currency and fiat money relate to types of currency or money whose usefulness results not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government's order (fiat) that it must be accepted as a means of payment.

Why is this important on how you build wealth. Because since banks can now print currency unrestricted by the amount of gold they held, most countries now just print money for so called government spending(including in India, where we do a lot of this. US is also doing this to get out of the current recession).

This leads to what we call Inflation. Inflation is one of the most important things to consider when you think about wealth creation. Inflation will be our next topic.