What is Investing?

What is investing

Did you know that investing was discovered approximately 3,720 years ago?! It was part of the code of Hammurabi.

But even after 3,000+ years, the majority of investors still fail to understand what is investing. There is too much confusion between investing, saving and speculation.

Some investors believe saving money in their bank account is investing.

Some investors believe buying a lottery ticket or gambling is investing.

Unfortunately, they are all wrong!

In this article, we will take a detailed look at what is investing. We will also cover:

  • Basics of Investing
  • Types of Investments
  • 3 Most Important Investing Strategies
  • Top 10 Investment Options

What is Investing?

You must have seen a big ‘Peepal’ tree in your area. How do you think the tree grew so big? Was it this big since the beginning?

Investing is exactly like planting a seed.

Investing is putting aside money to buy an asset. This asset is expected to generate income or profits in the future.

The goal behind investing is twofold:

  • Capital Appreciation: Buying an asset at a low price and selling it at a high price is known as capital appreciation.
  • Regular Income: Your investments also provide regular income. Income in the form of a dividend from stocks, interest from bonds or rent from real estate.

Common Examples of Investing

  • Investing in financial assets like Stocks, Bonds, Mutual Funds, Exchange Traded Funds (ETFs) etc.
  • Buying a property.
  • Pursuing higher education.

Yes, even pursuing higher education is investing. You are investing your money to acquire knowledge. This will help you get a bigger job (potentially).

To sum up, ‘Investing is any activity where you buy an asset today for future growth. The goal of investing is to increase your money over a period of time’.

It is important to note that profits or income are not always guaranteed in investing.

The uncertainty of profits or losses is known as Risk. Any form of investing carries some degree of risk.

Risk and Return in Investing

There is a direct relationship between risk and return in investing.

  • High-risk = High returns
  • Low-risk = Low returns

Assets like stocks, commodity, currency carry high-risk. Certificates of deposits, bonds, fixed deposits etc carry low-risk.

Risk and returns can vary significantly within the same asset class. For example: Bluechip stocks have low-risk. But midcap and small cap stocks have high-risk.

There are two types of risks in investing:

  • Risk of the asset losing its value over time
  • Risk of the asset NOT generating regular income.

Risk is the primary difference between investing and savings.

Savings is when you set aside money for the future. Your piggybank qualifies as ‘savings’. Your grandmother saving money in kitchen utensils is ‘savings’.

In savings, the money is not used to buy any asset. Since no asset is bought, savings does not carry any risk.

When you invest the money set aside in any asset to make profits, then your savings become investments.

Types of Investments

There are 3 types of investments:

  1. Ownership Investments
  2. Lending Investments
  3. Cash Investments

Ownership Investments: Ownership Investments is when you become owner of the asset. Stocks, Gold, Real Estate etc are types of ownership investments.

Lending Investments: Lending Investments is when you give a loan in return for interest income. Bonds is a type of lending investment.

Even your savings account is a lending investment. When you deposit any amount in your savings account, you are giving a loan to the bank. The bank then gives a loan to others and earns income. A portion of this income is given to you in the form of interest.

Cash Investments: Cash investments are easily converted into cash. They are highly safe and carry almost zero risk. But the returns are also very poor. Government money market instruments are a type of cash investments.

Three Most Important Investing Strategies

  1. Start as early as possible
  2. Stay invested for as long as possible
  3. Spread your risk

Investing Strategy #1: Start Investing as early as possible

We all know that the early bird gets the worm. But is this also applicable in investing?

Yes, it is!

When you start investing early:

  • You have the time to make mistakes and learn from them.
  • You get to experiment with different investment options.
  • You are more prepared to deal with market fluctuations.

Time is the biggest contributor to wealth creation. The more time your investments have to grow, the greater power of compounding they’ll achieve.

Power of Compounding is when you earn interest on interest. For example: Suppose you invested Rs 10 on 1st January 2010. You earned a 10% interest on this.

  • On 1st January 2011, the value of your investment would be Rs 11 (Rs 10+10% interest)
  • In the next year you earn 10% interest on Rs 11, not Rs 10. So, in 2012, the value of your investment will be Rs 12.10.

In power of compounding, you keep on earning interest on interest. This leads to huge profits.

The below table shows how starting early leads to higher returns.

Particulars Ram Shyam
Amount Invested each month 10,000 10,000
Return on Investment 12% 12%
Started Investment at 25 30
Investment Years 35 30
Future Value 6,49,52,691 3,52,99,138

From the above table you can see that:

  • Ram and Shyam both invested the same amount Rs 10,000.
  • They both earned the same rate of return – 12%
  • There is a difference of a whopping Rs 2.96 Crores between Ram and Shyam’s wealth.

So, what happened?

The reason why Shyam made 50% less wealth is that he started 5 years later!

Yes, starting 5 years late will cost you Rs 3 Crores!

All this due to the Power of Compounding.

Investing Strategy #2: Stay Invested for as long as possible

When you stay invested for as long as possible, you give your investments plenty of time to grow. Having a long-time horizon helps you invest in riskier assets as you can average the returns over a long period.

Particulars Ram Shyam
Amount Invested each month 10,000 10,000
Return on Investment 12% 12%
Started Investment at 25 30
Investment Years 35 30

As you can see above, by staying invested for 30 years (5 more years) you can increase your wealth by 86%!

Investing Strategy #3: Spread your risk

Spreading your risk is also known as diversification. Diversification is when you divide the investment amount into smaller portions and invest in different asset classes. The idea is to reduce your risk.

Let us see how diversification works. Suppose you want to invest Rs 1,000. You have 2 options.

  • Invest entire Rs 1,000 in just 1 asset
  • Divide and invest Rs 200 each in 5 assets.

Scenario 1: Investing the entire Rs 1,000 in just 1 asset class.

Asset Investment Amount Returns Weighted Average
Asset No 1 Rs. 1,000 -10% Rs. 900
Asset No 2 Rs. 1,000 12% Rs. 1,120
Asset No 3 Rs. 1,000 -15% Rs. 850
Asset No 4 Rs. 1,000 20% Rs. 1,200
Asset No 5 Rs. 1,000 2% Rs. 1,020

This is similar to your chances of winning a lottery.

You can make maximum Rs 1,200 if you select asset number 4. But you can also lose 15% of your investment if you select asset number 3.

Your probability of choosing a positive asset is 0.33!

Now imagine selecting 1 stock from 4,500 stocks in the market! It’s almost impossible to pick the winning stock. Hence diversification is an important cornerstone of investing.

Scenario 2: Investing Rs 200 each in 5 assets.

Asset Investment Amount Returns Weighted Average
Asset No 1 Rs. 200 -10% Rs. 180
Asset No 2 Rs. 200 12% Rs. 224
Asset No 3 Rs. 200 -15% Rs. 170
Asset No 4 Rs. 200 20% Rs. 240
Asset No 5 Rs. 200 2% Rs. 204
Total Rs. 1,000 2% Rs. 1,018

In this scenario, while your average returns are only 2%, its much better than losing 15% of your investment.

When you invest in different asset classes, the poor performance of one asset class is compensated by the superior performance of another asset class. The overall risk of the portfolio greatly reduces when you diversify your investments.

Types of Investors

When it comes to investing, there are 2 main types of investors:

  • Active Investors
  • Passive Investors

1. Active Investors actively buy and sell assets to make short-term profits. Their goal is not to generate long-term income. The goal is to beat the market benchmark. Active investors continuously churn their portfolio and hence end up paying high management fees, brokerage charges and taxes!

2. Passive Investors: Passive investors buy and hold assets for a long time period. Their goal is long term capital appreciation. These investors invest in assets based on fundamental factors. Passive investing is considered to be the best long-term investment approach.

After covering the basics of investing, the next step is to understand the various types of investments.

Top 10 Investment Options

1. Stocks/Shares

Stocks are one of the most popular investment options. When you buy shares of a company, you get proportionate ownership in the company. You get to participate in the company’s profits and losses. You also get voting rights.

There are two types of returns in stocks –

  • Capital appreciation: When the value of your stock increases.
  • Regular Income: Stocks provide regular income in the form of dividends.

Since the value of stocks is dependent on the company’s future, stocks carry high risk. The biggest risk in stocks is market risk.

Market risk is when the value of your investment reduces. Suppose you invested Rs 100 in stock ABC. After a year three things can happen:

  • Your investment grows to Rs 110 – 10% Gain
  • Your investment remains Rs 100 – 0% profit/loss
  • Your investment falls to Rs 90 – 10% Loss

The risk of your investment falling or not making returns is known as market risk.

[Suggested Reading: 12 Best Investment Options in India for 2021]

2. Bonds/Fixed Income Instruments

When you invest in bonds, you are investing in ‘Debt’. Debt is a loan. This loan can be given to private or public companies or even to the government.

Like any other loan, this loan or debt also carries a fixed rate of interest. It also has a fixed maturity date. Since the interest and maturity are fixed, bonds are less risky. In India, bonds, debentures are very popular among low-risk investors.

Other debt instruments like Public Provident Fund (PPF), Senior Citizens Saving Scheme (SCSS), Post office saving schemes etc are also popular among low-risk investors.

3. Mutual Funds

Mutual funds are one of the most popular investment options. They offer very high diversification.

Mutual funds collect money from lakhs of investors. This money is then invested in various assets based on the type of mutual fund.

  • Equity mutual funds invest in stocks of companies. These can be large cap funds, midcap funds and small cap funds. Large cap funds carry low risk. Midcap and small cap funds are very risky.
  • Debt mutual funds invest in debt instruments. Debt securities include: Treasury Bills, Certificates of Deposits, Commercial Papers etc. Debt mutual funds carry lower risk than equity funds.
  • Hybrid mutual funds invest in both equity and debt. The allocation is based on the type of hybrid fund. Aggressive hybrid funds invest 60% in stocks. Conservative hybrid funds invest 40% in stocks.

4. Exchange Traded Funds (ETFs)

ETFs is a type of passive investing. These funds are exactly like mutual funds in structure. But ETFs can be bought and sold on the stock exchange, like shares. ETFs provide high liquidity and have low costs.

5. Investment Trusts

Investment trusts are also a type of ETF which is traded on the exchange. In India Real Estate Investment Trust (REIT) is starting to gain popularity. REITs invest in commercial properties. The rent received is distributed among investors as dividends.

6. Commodities

Like stocks, even commodities such as wheat, pulses, oil, natural gas etc is bought and sold on an exchange.

The four major types of commodities traded are:

  • Metals – Gold, Silver, Platinum
  • Energy – Crude Oil, Gasoline, Natural Gas
  • Agriculture: Wheat, Paddy, Maize
  • Livestock – Eggs, Cattle

The Multi Commodity Exchange (MCX) & the National Commodity and Derivatives Exchange Limited (NCDEX)are two major commodity exchanges in India.

You can invest in commodities in 5 ways:

  • Commodity ETFs
  • Commodity Mutual Funds
  • Commodity Options
  • Commodity Futures
  • Physical Commodity

7. Currencies

The global currency market has a daily turnover of 6.1 Trillion US Dollar! It is the most liquid market in the world. In India, you can trade currencies only through registered brokers. You can trade in the following contracts:

  • INR/USD
  • INR/GBP
  • INR/EUR
  • INR/JPY

Trading in currency requires solid research of factors affecting currencies. Currency markets are very volatile during events such as election, war etc.

8. Real Estate

Real Estate is one of the favourite investment options for Indians. Real estate offers both capital appreciation and rental income. But real estate is highly illiquid.

Liquidity is how quickly you can sell an asset. The value of real estate is largely dependent on its location. Real estate investments come with huge costs – maintenance, stamp duty, registration, tax on sale etc.

9. Gold

Gold is popular among investors as it is a hedge against inflation. It is an increase in general price levels. For example: A car costing Rs 5 Lakhs today will cost Rs 5.5 Lakhs after 1 year @10% inflation.

Inflation reduces the purchasing power of money. In times of high inflation, investors switch to gold as it preserves the value of money. Between 2010 – 2020, gold has given an absolute return of over 116%!

There are multiple ways of investing in gold:

  • Gold ETFS
  • Gold Mutual Funds
  • Physical Gold (Jewellery, Coins)

Investors prefer investing in gold mutual funds and ETFs as it reduces the risk of theft, loss and storage costs.

10. Insurance

Insurance policies are also a popular investment option in India. However, majority of insurance policies have generated mediocre long-term returns. While popular, Unit Linked Insurance Plans (ULIPs) carry very high policy charges. Hence, ideally insurance and investment should not be mixed.

Final Thoughts

As Paul Samuelson aptly remarked, ’Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas!’.

Similarly, a long term ‘buy and hold’ investing strategy is the best way to create wealth.

Remember the three investing strategies –

  • Start as early as possible – Possibly today!
  • Stay invested for as long as possible
  • Diversify!

We at Samco help you in implementing all three investment strategies. Our StockBasket and RankMF platforms are built on the principle of long-term wealth creation.

StockBasket provides expert curated baskets of top-quality stocks. StockBasket’s Digital India basket gave 67.14% returns in 2020. Open a FREE StockBasket account today and invest in best stocks in India for long-term wealth creation.

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