Every once in a while I get these questions from friends and family members:
1. What should I invest in?
2. Is this the right time to invest?
3. How much should I invest?
4. Is the stock market safe?
And so on. These are fundamental questions that we all grapple with at some point in our investing journey. However, the first question to really ask and answer is why am I investing?
The main reason for investing is to preserve the purchasing power of money for future consumption which means investment return must exceed inflation. The future consumption could be in a few months time or several years away. How far away the consumption is will largely determine what assets you invest in. Therefore, determine your purpose for investing and your horizon before you make any other decision.
What should I invest in?
The decision to invest in a particular asset is largely driven by your holding period; that is how soon do you need the money? If you need the money in a few months, then assets with short-term maturities are your best options. If on the other hand your holding period is several years, for example if you are saving for retirement, then assets with long term maturities are more suitable.
Assets are usually classified as follows:
1. Fixed income assets (or securities). These include Time Deposits, Commercial Papers, Treasury Bills (short-term maturities of a year or less) and Bonds, both government and corporate which have long-term maturities. These assets all pay a fixed income i.e. interest.
2. Equities. That is shares of companies quoted on a stock exchange. These are riskier than fixed income securities as they pay no fixed income. The company can decide to pay a dividend or not and there are no guarantees as the company can also go burst.
3. Real estate. This could be residential or commercial. Income is by way of rent received and capital appreciation of the property.
4. Alternative assets. These include private companies or private equity funds, gold and other precious metals, art etc.
If you have a short horizon, then invest in short term fixed income securities. If your holding period is several years then bonds, equities and real estate are your best bet. Alternative assets are usually for people with plenty of money.
Is this the right time to invest?
The sooner you start investing the better, as time is your friend due to compounding. Generally, market timing is exceptionally difficult but there are times when the market is in a panic mode and you are better off waiting it out. You need not be a genius to figure out that 2008 and early 2009 were tough times for real estate and stocks. At such times you can invest in short-term securities issued by governments and solid banks that are too big to fail or keep cash.
Having said that, except in such exceptional circumstances, you should plan to invest slowly and consistently. For example, you can set aside some percentage of your monthly pay for investing. This way, if you are investing in the stock market, you average down your cost of purchase rather than investing all at once and risk buying at the top. The beauty of the stock market is you can invest small sums which makes it easier to do if you have the discipline to sacrifice a little of your pay cheque.
Obviously you can’t average down real estate. However, any cash meant for real estate investment can be warehoused in a fixed income investment until a suitable property at the right price turns up.
How much should I invest?
This one is easy, as much as you can spare! A rule I have found useful is to invest at least 20% of my monthly income. This is suitable for young people investing for retirement, which is a long way out. However, if you are getting close to retirement, for example if it is less than 15 years away, then 30% or more of your income should be saved. There are online calculators you can find that can help you make some rough estimates. Be careful though as the answer you get is contingent on your assumptions.
Is the stock market safe?
This one is tough. It is certainly riskier than investing in fixed income securities but you are more likely to get returns above inflation which is one of the principal goals of investing. My general advice is invest only in good companies when they are selling at reasonable valuations. This way, you reduce the risk of loosing money.
In a nutshell, determine your purpose for investing, start early, do it consistently, choose your assets wisely and pay attention to the price you pay.