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Most of us use the term saving and in vesting interchangeably. However if you want your money to work for you, it is important to understand the difference between the two. Saving is a passive decision, investing is active. So, if you ear n Rs 1,000 and spend Rs 800, you save Rs 200.
This Rs 200 accumulates in your savings account by default, or you may route it into a recurring deposit, fixed deposit or a money market fund. People who save do not want to take any risk with their money. They certainly do not want Rs 200 to drop to Rs 190. They expect capital to be secure, even if returns are low.
Investing is a different ball game. When you invest, you expect to take some risk and hence be compensated for the additional risks. You want to generate returns that are higher than inflation, so you can plan for your long term goals such as children's higher education or retirement. Clearly savings will not help you meet long term goals, since the post-tax returns from such investments barely beat inflation. Savings are meant to meet short term goals or expenses. You do not want to hold on to too much savings because the opportunity for this money to grow is limited.
It is important to have the right mix of products in your portfolio so that they beat inflation and enable you to get wealthy over time. Your age is a good indicator or the amount of safe investments you need in your portfolio. If you are 40, then have 40% bonds or other risk-free instruments in your portfolio.
The remaining 60% can be invested in riskier investments which have the potential to deliver higher returns over time. These could be stocks, equity mutual funds, exchange traded funds and maybe some real estate. Such investments must align with your goals, time horizon and risk appetite. This is important since investing is usually for the long term. Investing for the short term may cause liquidity issues or force you to exit an investment at a loss.
With inflation hovering between 8% and 10%, we need to make our money stretch more than inflation so that we can move forward toward our goals and not run on a treadmill where we're trying hard to remain in the same place.
So, say, you are a 30-year old and your current expenses are about Rs 3.6 lakh a year. Assuming your expense patterns don't change throughout your life, you will be spending Rs 36 lakh for the same set of expenses when you are 60, assuming inflation is at 8%, and when you are 90 you would be spending Rs 3.6 crore.
Many of us are risk averse and are comfortable investing in traditional risk-free investments such as savings deposits, FDs and bonds like NSC, Kisan Vikas Patra etc. Even though some of these instruments offer around 8 1 0 % i n t e re s t , the interest is taxable.
Post tax, the yield can come down to as low as 6-6.5%.
With inflation in the 8-10% range, these instruments deliver negative real returns.
Sometimes the biggest risk to financial independence is not taking a risk at all.
There are several instruments that offer returns that beat inflation. Good equity funds can earn you annualized returns of between 14%18%, thereby comfortably beating inflation. Capital gains are also tax-free after a year. Earning an income through systematic withdrawal plans of mutual funds can be a much more tax efficient way of generating income. These plans are flexible, so you can stop them when you want. You can also increase the withdrawals each month if inflation catches up with you.
To bring safety to your portfolio, you can invest in good debt funds. Contrary to popular opinion, there is more money invested in debt funds than in equity funds. This is mostly due to the tax break you get in mutual funds, compared to bank accounts and fixed deposits. If the investments are held for more than a year, fixed maturity plans or other debt mutual funds are a more tax efficient way of generating better returns than fixed deposits. Liquid funds offer the ability to plan for an emergency, vacation or any short term goal by generating far superior returns compared to a savings account.
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