This article looks at a very radical question. Why do you need to invest? And really why do you need to, wouldn’t you be better off spending all that money you earned. Well, check it out for yourself.

Do you really need to invest? What are the benefits of investing? This article takes a closer look at these fundamental issues.

Before we start delving into the intricacies of investing, let us look at one basic question. Why invest?

Yes really, why should you invest your money? Wouldn’t you be better off keeping it at home or just spending it? Lets look at both the scenarios.

The price attack:
Well as you know, prices of commodities and almost all the items keep increasing over a period. This, mostly known as inflation, causes your money value to shrink. Now inflation is caused by a variety of things like scarcity of commodities, increase in production costs, calamities, more money chasing few goods. Leaving that aside, fact is that prices rise. And this price rise curbs your purchasing power.

Lets, for instance, assume that you had Rs.100 in the year 1990 and a apples in the year cost Rs.10 and therefore you could be able to purchase 10 apples. Now assume that the prices of apples move in tandem with the inflation rate. And the average inflation rate from 1990 till 2001 has been 4 per cent, meaning prices rose by 4 per cent every year.

So in 2001, the cost of apples would roughly be Rs.15.40 per apple. This means that your Rs.100 can enable you to purchase six and a half apples instead of 10 apples in 1990. Your purchasing power has deteriorated.

So, to guard the purchasing power of your money you need to invest it in avenues that provide you with returns that beat the inflation rate.

Consumption argument:
But then you could argue and say, who wants to purchase at a later date. Why not consume all the money now and still be better off. Well you could, but then you also need to save some money for a rainy day.

Regular investing would help you tide over difficult times. More than that it would help you fulfil your dreams, ambitions and help you fulfil your social obligations like children’s education, marriage and all.

The earning factor:
Besides this, investing is also a means to earn income. Smart investing and generating handsome returns could make you a professional investor and enable you to earn decent returns. Investing is also a business after all.

The national factor:
Lastly, investing money prudently fosters national growth. The money you invest, say in a company, would enable the company to start a business venture, employ people, pay them and make profits. This means that jobs get created and opportunities made available when you invest your money. So investing also means that you do your bit for the national cause. Never thought of that, did you?

Investing is quite like a game. There is something at stake, and you could win, or lose or draw. And like a game, there are some basic rules to investing, there are some premises inside of which this game takes place. Read this article to find out more. This article looks at the investment game and what is up for takes.

So after knowing that investing is a good habit that stands you and the nation in good stead, we then look at what are the basic premises in which investment takes place.

Now, if you play football, you know that there are certain premises, certain rules or assumptions like the aim is to score a goal, the team that scores the maximum goals within the stipulated time wins the game and so on. Likewise, the game of investing too has a premise or certain rules.
Lets look at them:

Investment games and objectives
Knowing the objective for which an investment decision is taken is the first and the most crucial step in the game of investing.

So when you have money to invest, you could place it in many avenues. Like there are many games to play, you could play the one that interests you the most or you could play a game which you understand well or you could play a game that gives you the thrills. So depending upon your intentions of what you want to get out of the game, you play it. Similarly, you can invest your money in various modes of investment depending upon what you want to get out of the investment.

Yes we are talking about investment objectives!

This is a very important factor that you must look into before you even decide to make an investment decision and chose the investment avenue. It does not mean that you would not win if you are not clear about the objective, but it will be more like a gamble. And, chances are that you would not be able to repeat the performance.

On the other hand being clear about the investment objective does not mean or guarantee that you would win. It just gets your path cleared of what you can expect, and then allows you to plan effectively to maximize your returns keeping the objectives in mind.

So when you have money to invest, you could place it in many avenues. Like there are many games to play, you could play the one that interests you the most or you could play a game which you understand well or you could play a game that gives you the thrills. So depending upon your intentions of what you want to get out of the game, you play it. Similarly, you can invest your money in various modes of investment depending upon what you want to get out of the investment.

So if you want to have cash ready to be spent for your house after a period of six months, investing your money in tax saving bonds that have a lock in period of three years would not make sense or serve the purpose.

Now, to zero on your investment objective would require you to look into your life and see what your priorities are, what your dreams are and what is your ability to invest. Therefore, investment objectives differ; the objective of a young executive would be different from that of somebody who is retiring next year.

Each time you look at these objectives you should see what applies to you most. Here goes:

Risk is the all-pervasive factor that you have to consider before making an investment. There is no state like ‘no risk’. All investments have risks.

Getting clear about your investment objective is the first step towards taking an investment decision. Then there are some more deliberations you need to do before you start off. One of the most important deliberations you need to do is get a working relationship with the four-letter word ‘RISK’.

Risk can be roughly defined as a possibility of coming across some danger, or suffering a harm of loss. Now you don’t need to get scared and petrified by this. Risk is an inherent all pervasive part of life. “Security is mostly a superstition, it does not exist in nature. Nor do the children of men as a whole experience it. Avoiding danger is no safer in the long run that outright exposure,” said Helen Keller.

True enough, even if you decide not to invest and keep all your money home, safely dug up deep in your backyard, you still have the risk of it rotting or getting robbed.

So the fist place to start off is by knowing that ALL investments have risks. Just for the sake of repeating - there are no investments that do not have risks – every investment avenue has a risk attached.

Now, lets look at some basic type of risks involved with investing:

When you take a look at risk you need to keep a few things ready in the background. One of the most important factors is to be clear about your investment objective.

As we saw in the previous article, risk is all pervasive and there is no investment that is risk free. So when you are home with this reality, you can start looking at investments in a different, more practical light.

The next question that creeps up now is – How much of risk are you willing to take? Answering this would require you to do some introspection. Just as you were getting clear with your investment objective, you require reviewing your life and your aspirations. And now, when you take a look at risk you need to keep a few things ready in the background. One of the most important factors is to be clear about your investment objective.

Okay now, there are two factors that should shape your decision on taking risks. They are:

You have to mix and match risks and returns based on your willingness and ability to balance each element.

So this is the game, the investment game! There are monies to be risked and there are returns to be gained. And you have to mix and match these two properties based on your willingness and ability to balance each element. This, you would do after you have carefully looked into your expectations your aspirations, basically your investment objective.

All this has been written about in the previous articles.

Now we look at the real thing. We look at the various investment avenues and compare them to the three most important factors. The risk factor, looks at the extent of danger your money is in, the chance that you would lose your money. The liquidity factor looks at how fast you would be able to convert your investments back into cash. And the returns potential looks at what rewards are likely to come your way.

After you have done all the introspection, like, having looked at why and for what reason you would want to invest and how much of a risk you are willing to take, you should take a careful look at this matrix and decide which investment suits your investment objectives and fits into your needs.

The way to read this table is to look at the investment avenue and then the risks or returns that match with the avenue. Or, the other way around, you could look at the important factors that match with your objectives and then look for the avenue. At the bottom of the matrix, we have explained the key terms as well.
Tip: look at maximizing returns and minimizing risks.

The Investment Matrix

Okay, so you now have a fair idea of the investment scenario. But this is just the beginning of the action.

Take a look at fundamentals behind the working of simple and compound interest.

This is the most crucial part of the investment game -- the score! The extent of returns decides whether or not you have won the game. And it also tells you how effective you have been in investing your money. So this is the most important part!

Much often, the returns part of the game does not interest many. It is too cumbersome, say some; others do not understand the way the mathematics works. And many are just not bothered at all.

But then, not paying heed to this part would be like playing a cricket match or a football game not being bothered or least interested in knowing the score. While it can be fun, it may also end up being a wasted effort. And we guess money is one thing you would not want to lose in a wasteful game.

So lets not waste time, lets gets started at the rudiments of the game straightaway. First we will look at the basics, and then at their applications and power and finally we will move onto more erudite topics.

Simple Rate of Return or Interest:
First of all let us visit the basics of investments – the simple rate of return or the simple interest rate. At this point in time we will not look at any complex investment avenue and stick to the mechanism of borrowing and lending. So when you lend out money, the return you get is the interest on it.

Simple interest is pretty simple. You had Rs.100, which you invested for 5 years in a deposit that fetched you 10% per year or per annum, which is Rs.10 a year. So the question is how much would your money be after 5 years. The amount would be Rs.50 in interest and you would also have your principal amount Rs.100 back, so a total of Rs.150. Simple school math right! But, lets get some system in here – the language of money and finance. So in ‘interest rate speak’, the money that you invested had a ‘present value’ of Rs.100. Its ‘future value’, the amount it will grow to with this investment in 5 years is Rs.150.

The General Rule in Simple Rate of Return or Simple Interest



So each time you have a straight investment to make, you could use these formulae.

Compounded rate of return or compound interest

Now, in the real world, often simple interest is not used. The earnings on your investment often get reinvested. So now the interest becomes a part of the principal and earns interest as well. The interest that earns interest is called compound interest.

Suppose you invest Rs.1,000 for 12 months at 10%, after a year you generate Rs.100 as interest. Had you collected your interest every six months, at the end of the six months, you would have collected Rs.1,050 with Rs.50 as the interest. Now, had you invested the entire sum Rs.1,050 for the next six months you would have received a total of Rs.1,102.5 as compared to Rs.1,100 a month. Very crudely put, this amount is simple interest calculated twice.

The most important factor in any interest rate calculation is the interest accumulation factor, or (1 + r) as we saw in the simple interest calculations. In the case that we looked at, the interest accumulation factor was 1 + (0.10/2) which is 1.05. So after first six months the sum due is Rs.1,000 ´ 1.05 = Rs.1,050. This higher sum earns the same rate of interest for another six months Rs.1,050 ´ 1.05 = Rs.1,102.5. The same could also be written as Rs.1,000 ´ 1.05 ´ 1.05.

Now, suppose you did the same thing every four months, that is you accumulated interest every four months and reinvested the same amount at the same rate of interest, then your interest accumulation factor, or the rate at which your interest grows would be 1+(10/4) = 1.025. And this time the amount that you would have received would be Rs.1,000 ´ 1.025 ´ 1.025 ´ 1.025 ´ 1.025 = Rs.1,103.81, and this again is more than the amount you would have got by investing in a simple interest instrument.

Mathematically speaking, two things happen with compound interest rates. The interest accumulation factor shrinks as the frequency of compounding increases. So we saw 1.10 for a year, 1.50 for six months and 1.025 for four months, shrink each time the frequency was increased. It can be expressed as 1 + (i/k), where i is the rate of interest and k is the number of conversions in a year.

The second thing that happens is that the multiplier is multiplied by itself once for each conversion period; so we have 1.025´1.025´1.025´1.025 which is also 1.0254. And this can be easily calculated on a scientific, or a slightly advanced, calculator. So if you are calculating the amount you would receive after investment of Rs.20,000 earning 10% every three months (that is four times) a year, you would have to look at the xy button on your calculator. And you would punch in, 20,000´1.025 xy 4 and you would get the amount as Rs.22,076.25.



Now, all this compounding might seem complex. But at the moment, just get familiar with this. The next series would be on the power of compounding and how you could use this to your benefit and also look at some smart ways at using interest rates.

Eventually, it is your judgement brought about by qualitative factors like the company that you are investing with, the nature of the investment, the risks involved, which will hold you in good stead.

Eventually, it is your judgement brought about by qualitative factors like the company that you are investing with, the nature of the investment, the risks involved, which will hold you in good stead.

Apart from interest rate calculations, there are a few other techniques to measure investment performance. These tools are extremely important as they are used across all investment avenues. So you should be using interest rate measurement techniques discussed in the earlier in conjunction with these principles.

Again we get a bit radical. We shall keep doing this at regular intervals, because, often many investors get into the trap of forgetting why they invest. So it is a useful exercise to give perspective to our deliberations.

At the very basic level, we invest to see our money grow in value. Essentially get returns. And for this, we take a risk and invest this money in investment avenues. For this we chose amongst the available investment avenues. Keeping all the available investment avenues in mind, the question that pops up now is, how much of a return should be adequate from a particular investment avenue?

The way to do this is to look at this equation:

Required Rate of Return = Risk Free Rate of Return + Risk Premium

In this, the rate at which there is no risk of any sorts is termed as the ‘Risk free rate of return’. In the Indian context, it is investments in fully secured government bonds. So the rate would be around 7%, at the moment. This is the minimum available rate of return that you are getting in the financial market. So it should be the benchmark lowest rate for your investments. Because, without taking any risks, you are getting this return.

Now, if you take more risk, your returns should increase. So your required rate of return should be more than the risk free rate of return. Therefore, you have the required rate of return as a sum of the risk free rate of return and what is known in the financial markets as ‘risk premium’.

So if you are getting 14% per annum on a company fixed deposit, then you are getting a risk premium of 7%, considering 7% as the risk free rate of return.

The Inflation angle:

Putting it in another sense, the ‘inflation’ sense. The 14% return is the nominal return you are getting. So year after year, your nominal return would remain constant (considering there is no change in the basic interest rate on the fixed deposit) but since there is an inflation factor that is eating into your investment, you would actually be getting a lower return.

So if the inflation rate is 5%, then the real rate of return that you are earning is 14% — 5% = 9%. So we have:

Real Rate of Return = Nominal Rate of Return — Inflation

And then, putting it in the perspective of risk premium:

Nominal Rate of Return = Real rate of return + Inflation + Risk premium

Eventually, as you see in both the equations, it is the ‘risk premium’ that makes the critical difference. We shall look at various techniques to arrive at the risk premium. There are several statistical techniques involved, but these are very erudite in nature.

Eventually, it is your judgement brought about by qualitative factors like the company that you are investing with, the nature of the investment, the risks involved, which will hold you in good stead.

Get to know more about the practical aspects of measuring returns

After looking at the basic principle of measuring the profits you have made (previous articles), we now look at the more practical side of measuring returns. The basis of these measures is simple – how much money did you make over a given period of time.

The interest rate figure, or the dividend figure often quoted by organisation's soliciting investments often misleads or confounds investors. So the next time you read an advertisement, or when your friend tells you that a certain company made a heavy dividend payout, just don’t get carried away. Sit back and get to the bottom line. Ask yourself the most important questions – At the end of the day, how much will I earn actually. Or, how much will this investment yield?

And the way to check that out is to actually calculate the yield. Lets look at the basic technique – the Dividend / Interest yield.

This can be measured as:

Interest or Dividend Income X 100 / Investment price

Suppose you heard of a bond paying 20% interest available in the market for Rs.150. The immediate reaction would be to think that you would receive Rs.30 as interest. But that might not be the case. Often interest rates and dividends are declared on the face value and not on the market price. Especially in India where the concept of face value is still prevalent!

In this case, the money you would receive for the bond with a face vale of Rs.100 would be around Rs.20. Now that is a big difference. Wait, there’s more; your actual yield rate would be still lower.

Calculating the yield: Rs.20 / Rs.150 X 100 = 13.3 %

So you would get Rs.20 on an investment of Rs.150 and the yield works out to 13.3%, much lower than what you heard. Now, there are times when yields are often attractive and many investors skip such interesting avenues. There are times when sound companies with low share prices have been declaring decent dividends.

This usually happens when the market sentiment is weak and the fundamental performance of the company is steady. So a steady performance enables the company to declare a dividend and the weak sentiment causes the price to be depressed. All of this makes for an excellent investment opportunity. So investors should also keep looking at yields very closely.

Here is the follow up to the previous article detailing the practical aspects measuring returns Looking at the real side of quoted interest rates and dividends announced is what we did in the previous article. This article is a conclusion for the ‘measuring returns series’. In this, we look at the way investors should be measuring returns.

And, the way you can do it is called the ‘Total Return’ or ‘Holding Period Return’. As the name suggests, it takes into consideration all the factors involved in an investment. And these factors are: