10 Golden Rules of Investing

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17 Dec, 2012, ECONOMIC TIMES

10 golden rules of investing:

How to secure your financial future

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For an intangible entity, time is starkly palpable. It seems to strum with glee when you make

swift gains in the market; it's a sentient savant when you suffer losses; it can be an irksomesprinter for the ageing saver; a sluggish bore for a young trader. But mostly, time is a

capricious companion, loyal to none, yet equanimous to all.

We, at ET Wealth, have not been immune to its caprices, swept as the rest into its contrarianfold. So, during the economic slowdown, into which we stepped with our launch on 13

December 2010, we felt laden with our readers' expectations. However, two years later,

having navigated you through financial undulations, we feel leavened by your response.

Through it all, we have tried to maintain our own equanimity, which stems from our acute

perception of your needs and the deep insight into personal finance. Between fielding time's

whimsies and setting you on the right course, we have reached another milestone - we have

turned two. It's a special occasion because in this short span we have learnt to tweak time's

truancy to our advantage. In its contortions, we have found a constant.

We call it the Golden Rules of Investing. A synthesis of the past learnings, these principlesare our way of celebrating the present by securing your future. The mark of any rule is its

universality and ability to transcend time. What we have framed for you are 10 canons that

are based on these benchmarks, a compilation of our previous stories. They will act as abulwark for your finances against the attenuating swipes of time. They will hone you into an

aware investor in sync with your needs.

Most importantly, they will help you grow your wealth, so that we can keep the promise we

made at the time of our launch - that we would lead you to riches in this golden decade of

investing. In the following pages, we will tell you how to build a safe portfolio; how to work

towards a fret-free retirement; ways to defend against the crushing impact of the unforeseen;

how to juggle your portfolio and when to cut your losses; how to deal with the trap oftaxation; how to make the distinction betweeninsuranceand investment; the much-
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brandished benefits of diversification, and why you need to factor in the eroding effect of

inflation.

In essence, we offer a seminal guide that spans the gamut of personal finance. Still, our work

remains unfinished. For, even though the country's fiscal fate appears to be altering, thanks to

the proposed reforms, the world has not quite remedied its economic ills. And while

regulatory activism spells hope for the small investor, the responsibility to secure your

finances ultimately rests with you. So time shall continue to remain a pulsating presentiment

and will not stop throwing challenges at you. But you shall not be alone; we atET Wealth

will guide you through all your financial travails. And together we shall learn to tame time,

perhaps even befriend it.

Rule 1: Know your worth before you begin

To reach the finishing line, you must first know where the race begins. As any financial

planner will tell you, figuring out your net worth is the first step towards formulating a

successful financial plan. The best way to do this is by drawing up a list of your assets and

liabilities. Use the table on the right to calculate your net worth.

It will also give you a broad idea of your current asset allocation. Taking stock of your

current status is necessary to help you make informed financial decisions. The slowdown may

have affected your annual increment. Volatility in the stock market may have prompted you

to stay out. Before you plan to invest, sit down and take a fresh look at your financialsituation. Once you have figured out where you stand, find out your attitude towards

investing. Your ability to take risks determines theinvestmentsyou should opt for. If yourstomach churns whenever theSensexgoes into a freefall, equity is not for you.

Stick to the safety of debt options or take exposure tostocksthroughmutual funds. On the

other hand, if a 20-25% fall in value doesn't upset you, equity can be a great way to build

wealth. Another important trait is the keenness to conduct research before investing. Somepeople love nothing more than digging into financial statements and crunching numbers,

while others might not have the time or inclination to plough through prospectuses and

product brochures.
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Rule 2: Don't invest in a product you don't understand...

Most of the people who write to us seeking financial advice haveinvestmentsthey don'tunderstand. They are likely to know every random feature of their Rs 8,000 cell phone, but

will be clueless about theirinsurancepolicies that are worth lakhs of rupees. Before youinvest, you must fully understand how the product works and how you will gain from it.

There are several products (especially insurance plans) that promise the moon and have

complex features. Avoid these sophisticated products if you don't understand them. Investing
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in something that you do not understand is gambling with your money. Instead of the

structured products being sold in the market, the humble PPF can also help build enormouswealth in the long term. Increase the investment by just 1% every year and you will have a

comfortable retirement


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...but don't skew your portfolio in favour of one asset

The above-mentioned investment rule does not imply that you concentrate your investments

in one or two asset classes. You may not understand equity, but this should not stop you from

investing in equitymutual funds. As long as you understand that the fund manager will

deploy your money in the stock market and your investment will move with the market, it is

good enough. There are investors who buy nothing butgold, or invest only in bank deposits.

Some invest only inreal estatehaving been conditioned into believing it is the safest asset.

The biggest problem with a concentrated portfolio is that a single crash can make you bite thedust. We saw this happen in 2008 when the equity market crashed. As the chart below shows,

a diversified portfolio cushions the risk and generates stable returns. So opt for

diversification.
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Rule 3: Do not invest and forget

Don't think your work is done after you make an investment. In fact, it has just begun. You

need to monitor and review yourinvestmentsand take corrective measures if they go off the

track. At least once a year, you should subject your portfolio to the financial equivalent of aCT scan. The outcome may not be very palatable, but some tough decisions are needed to
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keep the portfolio healthy.

The first thing to check in your portfolio is asset allocation. It could have changed because of

the market conditions and, perhaps, needs to be rebalanced. For instance, you may have

wanted to allocate 60% of the corpus to stocks, 30% to debt and 10% togoldand other

investments, but due to a fall in the equity market and rise in gold prices, the portfolio now

has 45% in stocks, 40% in debt and 15% in gold. You need to increase your allocation to

equity by buying some more and reduce the investment in debt and gold. The next thing to

consider is the performance of individual investments.

Take help from brokerage reports, news reports and expert comments when you size up the

stocksin your portfolio. Formutual funds, compare the scheme's performance with that of itspeers and benchmark. If you find it difficult to analyse your portfolio, or if your investments

are too disparate, take the help of an online portfolio tracker or money manager websites.

Besides, you need to keep your goals in mind when you review your portfolio. The exposure

to volatile assets should come down as you draw closer to a goal.
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Review portfolio in case of special situations

Experts say you should review your investmentsonce a year. However, some extraordinary

circumstances may require you to rejig it evenearlier. Here are a few such special situations:

Marriage

Wedding bells mean new goals, higher expenses

and a change in risk profile. Your investments

need to be overhauled. If your spouse also works,

your investible surplus will go up. Chalk out acombined list of goals and plan your investments

to reach them.

Birth of a child

The entry of a new member in the family means

additional responsibilities and expenses. You will

add new goals to your list and, therefore, need tochange your investment pattern. This may also

require you to increase your lifeinsurancecoverand establish an emergency medical kitty.

Salary hike

When your income goes up, your investible

surplus rises. Ideally, you should distribute the

excess amount across different asset classes in the

same proportion as your investment mix. You canincrease the SIP amount in your investments. You

may also want to add a financial goal to your list.


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Windfall

Any unexpected income or an annual bonus coming your way is another reason to change

your investment portfolio. If the money comes to you as a lump sum, put it in a debt fund and

start a systematic transfer plan to an equity fund.

Loans

If you have taken a loan, put off some of your investments to account for theEMIoutgo.

Rejig your investments by putting the non-essential goals on the backburner till the loan isrepaid. When you repay a loan, you will have a bigger surplus to deploy.

Black swan situations

A sudden movement in the stock market, such as the crash of 2008, may warrant a change in

your investment portfolio.

You may need to rejig your asset allocation before a year to adjust to the change in the

market sentiment.
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Rule 4: Look beyond price and past returns for real value

It is every investor's dream to buy a stock when it is priced low and sell when it zooms.

However, small investors take this a little too literally and buy penny shares trading at very

low prices. The price of a share is not an indication of its real value. A stock at Rs 5 may

actually be costlier in value terms than one trading at Rs 500.

Low price alone does not mean that the stock offers good value. To find out if a stock is fairly

valued, compare it with its peers on a few common parameters. Though the PE ratio is a good

way to identify cheap stocks, relying only on a single parameter may not always yield the

desired results. What you consider cheap in relative terms might actually be more expensive,

and vice versa. Investors have lost money in many seemingly cheap stocks, while high-pricedstockshave given spectacular returns (see tables).

This is because many of these low PE stocks may actually be costlier than their high PE

counterparts, based on other fundamentals. A high PE stock could be justified if the company

has high growth expectations, strong fundamentals, or has huge projects orinvestmentsin the

pipeline. A low PE stock, on the other hand, may be so valued because of poor earnings

growth, weak fundamentals or lack of further expansion opportunities. This argument is

stronger when it comes to mutual funds. Some investors thinkmutual fundswith low NAVs

are cheap. A fund at Rs 25 is not cheaper (or better) than one priced at Rs 250. The low priceonly means it is newer. Your returns will depend on how the fund performs, which, in turn,

will depend on how the market moves.
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Rule 5: Factor ininflationwhile calculating returns

Inflation affects everyone and its impact on the household budget is widely understood.

However, very few investors understand the impact of inflation on their investments.

This is a mistake because inflation should be factored into every calculation of your financial

plan.

Even a modest 5% annual inflation can widen the gap between your nominal and real income

to almost 20% in just five years.
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Over 40 years, this difference can widen to over 80%. So, don't plan your future based onnominal values.

Factor in inflation to know the real value of your income and investments.

The post-tax returns from a bank deposit, which offers 8.5% interest, will not be able to

match the rise in prices.

This is why planners don't recommend low-yield debtinvestmentsfor the long term. Instead,

they advise clients to take at least 15-20% exposure to equities to be able to beat inflation.

Inflation should especially be considered while planning for long-term goals like retirement

and children's education.

Also take into account the fact that your consumption basket changes over the years. When

you are single, education and healthcare inflation do not impact you (see graphic).

However, when you start a family, education expenses shoot up. As you grow older,

healthcare accounts for a progressively larger portion of your expenses.

Insuranceis another area where inflation should be taken into account.

A Rs 1 crore insurance cover seems sufficient right now, but this might change when you

factor in inflation.

Even 6% inflation will reduce the purchasing power of Rs 1 crore to Rs 40 lakh in 15 years.
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Rule 6: Buyinsuranceto guard against the unforeseen...

No matter how careful you are, an eventuality can play havoc with your finances. It could bea medical emergency that racks up a huge bill or the death of the family's breadwinner. The

only way to deal with these mishaps is to protect yourself adequately. Insurance is a cost-effective way to safeguard yourself against the unexpected. In fact, life insurance is one of

the most important ingredients of a financial plan. This one instrument secures all your

financial goals and aspirations. One should have a cover of at least 5-6 times one's annual

income. However, this is a rudimentary method and a more accurate calculation must take

into account your expenses, current assets and future financial goals. Use the table below to

find out the size of life insurance cover you need. Medical insurance is also very important.

The rise in cost of healthcare means that even 2-3 days in hospital can cost Rs 50,000-60,000.


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A medical cover will not prevent illness, but it will allow you to access the best hospital in

your city without burning a hole in your wallet. Take adequate health cover for your familyand yourself. If your employer offers you medical insurance, take a top-up plan to enhance it.

A personal accident cover is a little known, but crucial, form of insurance. It covers loss of

livelihood due to disability, temporary or permanent. Life insurance is payable only in case of

death and medical insurance covers hospitalisation expenses, but these policies will not pay

anything if a person loses a limb in an accident or has to miss work for a long period due to

injuries. This is where personal accident insurance will come to his rescue.

...but don't mix insurance with investment

Buying life insurance as an investment is probably the most common mistake stemming fromignorance. A life plan should be taken merely to secure one's dependants in case of one's

demise, not as a returnbearing investment. So, a unit-linked insurance plan or a traditional

insurance policy will not be able to give you adequate protection since a large chunk of the

premium goes as investment. Instead of these high-premium plans, which combine

investment with insurance, buyers should opt for term plans. These are pure protection

policies that charge a very low premium for a very high insurance cover.

For less than Rs 12,000 a year, a 30-year-old nonsmoker can buy an insurance cover of Rs 1

crore. If you buy online, the premium is even lower. Term plan premiums are low becausethere is no investment involved. These policies don't pay anything if the policyholder

survives the term of the plan. On the other hand, a Ulip that offers a cover of Rs 1 crore will

have a premium of Rs 8-10 lakh, while a traditional plan will cost roughly Rs 12 lakh.

Rule 7: Don't leave tax planning till end of financial year

It is a perennial problem. Taxpayers wake up in March when their employer sends them a


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notice seeking proof of their tax-saving investments. In the rush to complete their tax

planning before the 31 March deadline, many taxpayers make hasty decisions they regret atleisure. Unscrupulousinsuranceagents thrive on this panic. This is the time when they can

mis-sell high-commission products without the buyer asking too many questions or

examining the product in detail. Who would want to go through the policy features in small

print when the premium receipt has to be submitted to the office the next day?

This is a penny wise, pound foolish approach. If you buy an insurance policy that doesn't suit

you, the entire premium goes waste. To save Rs 2,000-3,000 in tax, you could be throwing

away Rs 10,000. Your tax planning should not be a kneejerk event that happens in March, but

a part of your overall financial planning. Instead of packing your entire tax planning into

March, spread it across the year and take informed decisions. You should buy an insuranceplan only if you need life cover. Invest in an ELSS fund only if you need to take exposure to

stocks. Lock money in the PPF, an NSC or a bank fixed deposit if you want to invest in debt.

Take a health insurance plan if you need medical cover, not because you get deduction under

Section 80D. The tax benefit is incidental, not the core.

Rule 8: Be prepared for a financial emergency

Will you be able to manage your finances if you lose your job today? Financial planners

advise that one should have a buffer fund to take care of a financial emergency. Thiscontingency fund should be large enough to meet at least three months' worth of household

expenses, including loan repayment and insurance premium obligations. An emergency fund

should be easily accessible and its value should not be subject to fluctuations. While an

investment in equity funds is fairly liquid, its value can go down when the funds are neededand beat the purpose of having such a corpus. Similarly, a home equity loan pre-supposes an

appreciation in the value of property, which may not always happen. A loan will also push uptheEMI, which might be tough when somebody is facing a loss of income. Although credit

cards are commonly used for emergencyfunding, they are useful if you restrict the credit to

one month. Otherwise, the cost is prohibitively high.

...but do not keep all of it in cash

While the need for a cash cushion cannot be stressed enough, the problem is that many of us
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hold much more than is needed for our short-term needs. Whether it is in your pocket or in a

savingsbank account, you incur costs. For one, the opportunity cost of holding cash is highsince you forego the chance to invest it to earn a higher rate of return. More importantly, the

cash in your account will lose value if you take the adverse impact ofinflationinto account.

If adjusted for inflation, the return from a savings bank account will always be in the

negative. Then there are the psychological costs of holding cash.

If you are not a disciplined spender and have a fat bank balance, it's quite likely that you will

give in to temptation and spend on discretionary items. Apart from the emergency fund, there

is no need to have more than 5-10% of your entire investing portfolio in cash. Financial

planners say this extra cash should be put to work. A mix of short-terminvestmentscan help

you retain liquidity as well as earn better returns. Depending on one's personal situation, onecan park the remaining amount in a short-term avenue, which is almost as liquid as a bank

account. For instance, debt fund redemptions reach your bank account the next working day.

Rule 9: Give precedence to retirement savings
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One of the biggest challenges for tomorrow's retirees is to ensure that they don't outlive theirsavings. This is a distinct possibility because of two factors: the rising cost of living and an

increase in life expectancy.

However, for many Indians, retirement is not as crucial as saving for their children. Whether

it is for their education or marriage, or even to provide them with a comfortable life, children

are the biggest motivators ofsavingsin the country.

This can be a problem because your retirement is going to be very different from that of the

previous generation.

Guaranteed pension, assured return from government schemes, relatively lowinflationand

the security of a joint family - the four pillars on which the previous generation's retirement

planning rested - have either gone or will disappear soon. What's more, you will live longer,

thus heightening the risk of outliving your money.

Before you pour money into a child plan, make sure your retirement savings target has been

met. Retirement planning should be your first and most important financial goal.

By this we don't mean you should neglect your child's needs, but you can borrow for almostall other goals, such as child's education, marriage or going on a holiday.

No one will lend you for your retirement expenses though. The early birds, who start putting

away small amounts from the day they start working, have a distinct advantage over lazygrasshoppers, who think of retirement planning only after the first grey hair makes an

appearance in their 40s (see graphic).

It is also important that you don't dip into your corpus before you retire. Withdrawing money

from your PPF account or missing the premium of apensionplan can lead to a shortfall in

your corpus.

If you want a dignified retirement, resist the temptation to withdraw from theinvestments

earmarked for your sunset years.
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Rule 10: Learn to cut your losses

Many investors believe that if they select a good investment and time their moves well, it is

enough. However, the decision to sell, especially at a loss, is not as easy. Financial experts

say that the small investor's portfolio suffers more due to incorrect decisions that are not

rectified in time. Holding badinvestmentsmay be worse than not selecting the right ones. To

be a successful investor, you need to have a selling plan in place and book losses if the

situation so demands. Behavioural economists contend that our refusal to sell an investment

stems from our aversion to loss. If our investment turns out to be good, we are happy to sell

and feel good about the gains. However, booking a loss is painful, so we tend to postpone the

regret we feel at having made the wrong decision.

We choose to wait out, ignore, or worse, add more to a poorly performing investment, hoping

to average out the cost. Therefore, cleaning up a portfolio is a tough task and calls for rational

decision-making. Low-yieldinsurancepolicies, dudstocksand poorly selectedmutual funds

don't offer any value to the investor, but there is a deeprooted aversion to get rid of them.

Many of the wrong decisions are taken when everything is looking upbeat. Those who bought

obscure infrastructure stocks at the height of the 2007 euphoria are st ill holding them, hoping

that they will be able to recoup their investment one day. Little do they realise that this is a

drag on their portfolio's overall return. Had they booked losses in 2008 and shifted the moneyto any average index-based stock, they would have got something back. It is also important

not to throw good money after bad. Don't book profits on good investments just to plough it

back into underperformers. You will only be left with lemons. It is better to ride the winners

than pump more money into losers.
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10 Golden Rules of Investing