It can be difficult to start investing at a young age. Your pay packet has to accommodate rent, mortgages, bills, and other numerous expenses, leaving you with barely enough. To add to the difficulty of eking out enough savings, the bewildering array of choices can make it even more intimidating. But when it comes to investments, the earlier you start, the more benefits you can accrue.
While the amount you can put aside each month may seem too small, the trick lies in investing it wisely. Starting early allows you to expand your money into a corpus that you can use to meet your financial goals, be it buying a car or an early retirement. It teaches you financial discipline and helps you to gain financial independence.
If you still find it a difficult journey to start on, here are six principles of financial planning to help you get an early start.
Decide on How You Want Your Style of Investing
As an investor, you can take either an active or passive approach. Active investing is a hands-on approach where you buy or sell stocks as per market fluctuations. It allows you to minimise risk, go for profitable trades, and create wealth in a short timespan. On the other hand, it requires constant monitoring of the markets, a good understanding of its functioning, and the knack to make prudent and quick decisions. It can also be more expensive since you’ll be paying a trading fee with each transaction.
In contrast, passive investing takes a more hands-off approach and focuses on long-term gains. The goal here isn’t to beat the market fluctuations, but to focus on allowing your portfolio to earn money through careful risk diversification across different assets. While a passive approach may be slower at generating wealth and may not allow for any dramatic returns, it is typically safer. It lets your money slowly grow towards a desired goal.
Ultimately, your preference will depend on how much time you can devote to your portfolio and your risk tolerance. If you have the time to devote to active trading and aren’t apprehensive of taking a few risks, an active investing approach may suit you perfectly. On the other hand, if you have other commitments, like a job, a passive approach may be more suitable for you.
Set Up Your Budget
The first thing you have to decide is the amount you can set aside each month towards your investment plan. There is no minimum amount here and you can start with as little as INR 100. The aim here is to pre-determine the minimum amount that you can earmark from your savings and then stick to the commitment. Setting a budget requires you to exercise financial discipline and minimize your spending.
But before you start looking at investment options, you must build your emergency fund. Depending on your expenses, an emergency fund should ideally be three to six months of your income. The purpose of an emergency fund is to ensure that you have enough money in the bank to tide over an unexpected expense without breaking your investment. Keep your emergency fund in a saving deposit which you can quickly access.
It also works in some cases to pay off your high interest debts, such as credit card debt. Alternatively, see if these can be transferred to lower interest plans. Remember, the interest is just an additional expense on your account with no returns.
Carry Out Risk Assessment
Understanding your own risk tolerance is the key to investment. Risk tolerance is the amount of risk you can withstand. It can be highly subjective, depending on your income, expenses, commitments, and mindset. People with a high number of dependents, debts, or expenses will have a lower risk tolerance. On the other hand, someone with generational wealth may be willing to take more risk.
Your risk tolerance will decide the makeup of your portfolio. Those with higher risk tolerance can go for high-risk, but high-return stocks. On the other hand, investors with low risk tolerance can go for low risk, but low return bonds. Even within these categories, there can be different risk profiles. For instance, blue-chip stocks will carry lower risk than lesser known stocks.
Stop-loss order: Whatever your risk profile, it is always a good idea to define the amount of loss you can bear. This is where a stop-loss order comes into play. It is an order placed with your broker to buy or sell a stock when it reaches a certain value. So, if you have set your stop-loss order at 15% your broker will sell a stock if it falls below 15% of its value.
Define Your Time Horizon
Time horizon is the length of time you expect to hold the investment to reach your financial goal. Your time horizon will typically be decided on the basis of your financial goal. For instance, investing to buy a car will have a far shorter time horizon than building a retirement corpus. Time horizon can be short-term (up to five years), intermediate-term (five to 10 years), or long-term (more than 10 years).
For a short time horizon, you can go for growth stocks with high returns. However, this may not be advisable in the intermediate or long-term where such stocks may mean higher risk. A mixed portfolio of stocks and bonds can provide an optimal balance for an intermediate portfolio. In comparison, a long-term time horizon allows for higher investment in stocks as you have the time to recover from a loss, letting the stock mature.
When starting young, you have the freedom to ensure a diversified time profile for your investments. Plan your investment for short, intermediate, and long-term with assets that mature at different times. Short and intermediate investments allow a periodic flow of cash which you can then reinvest or spend as per requirement. At the same time, a long-term investment ensures that a part of your portfolio is safe from any unnecessary spending.
Understanding Investment Options
The mind-boggling array of investment choices can seem bewildering and intimidating. But essentially there are three ways you can invest and see your money grow. The first is to lend someone money and earn interest on it. The second is to buy an asset that will appreciate in the future, such as gold or real estate. The third is to buy part ownership in a business and then earn a share in the profits.
All assets fall widely within these categories. When you put your money in a fixed deposit, you stand to earn through interest. However, these earnings are fairly limited. Earning through an appreciating asset can also depend on its performance. In addition, assets like real estate can take time to liquidate. You can opt for part ownership through equity. In this case, you have a chance to make a healthy profit if the overall stock performs well.
Each of these assets have their pros and cons and it is essential to understand each asset class. The most common of these are stocks, bonds, derivatives, cash or cash equivalent, gold, real estate, and commodities. While you should understand each asset class, it is also important to study the business, commodity, or property that you are investing in. Whether it’s a blue-chip company or gold, every asset is subject to market mechanisms.
Pro tip: If you are wondering about your asset allocation, that is, the proportion of stock to bonds in your portfolio, try this easy trick: Subtract your age from 100 to get the percentage of stocks in your portfolio. So, if you are 30 years-old, you might consider investing 70% of your wealth in stock funds. For a more aggressive approach, subtract your age from 110. In this case, your stock allocation goes up by 80%.
However, keep in mind that is just one of the many ways of stock allocation. You can choose to be more cautious by reversing the equation or deciding on a more equitable allocation.
Risk Diversification and Periodic Rebalancing
One of the golden rules of investment is to diversify your risk. Risk diversification of a portfolio means investing in assets with varying degrees of risk. The aim of risk diversification is to offset the potential losses from one investment across different assets. You can balance a high-return, high-risk stock with more stable investments like government bonds.
A well-balanced portfolio is spread across different asset classes with different risk profiles. Even within an asset class such as equities, you need to diversify by including stocks from different industries even if you are tempted to park your money in an industry or stock that seems to be zooming up. Remember what goes up can also fall with equal speed!
The size of the portfolio can also be a factor here. A large diversified portfolio can absorb most risks. A small portfolio may be wiped out if one asset performs extremely poorly. However, if it is balanced, you can still recover some of the losses.
Rebalancing portfolio: Another aspect of risk diversification is the changing nature of your own risk profile. Your risk tolerance can change with age and circumstances. For instance, your willingness to take risks can lower when you start a family or it may increase with a higher income. Age can also play a role as some people tend to get more cautious as they get older.
To allow for your changing priorities, you must rebalance your portfolio periodically. You should rebalance your portfolio at predetermined intervals, such as three to five months, or when your asset allocation has deviated significantly from your desired portfolio mix.
Bottom Line
There are many reasons an early start to your portfolio is highly advisable. What may seem like a meagre amount now will slowly grow and mature into a sizable corpus as you grow older. You can also enjoy lower premiums on assets like insurance policies. It also teaches you financial discipline. You learn the importance of money and why it should be invested properly. More importantly, it provides you with the freedom to make your choices.
