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Money matters: Rules of the game! - Views on News from Equitymaster
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  • Jun 21, 2006

    Money matters: Rules of the game!

    Financial ignorance is a costly affair. Not paying taxes on money because you did not think you had to, or you forgot you earned it, is a great excuse! Right behind that is the excuse that taxes are illegal. Unfortunately, both of them land you in jail. There are plenty of helpful money concepts. Understanding personal finance does not mean you will not make mistakes or face financial disasters. But you can lessen the odds and repair the damage faster if you know the rules of the game. In this article, we highlight some important rules to be followed with respect to managing your money.

    Needs and wants are different: This is the first rule to be followed. Needs is defined as goods or services that are required. This would include the needs for food, clothing, shelter, and health care. Wants are goods or services that are not necessary but that we desire or wish for. For example, one needs clothes, but one may not needs designer clothes. One needs food, but does not have to have dessert. Just about everything else is a want and wants are endless. Just because resources are limited we have to make a choice about which want to fulfill. Also the way we fulfill our wants involves choices for example, travelling in Maruti 800 or Mercedes Benz. Taking responsibility for the choices is difficult, but in the end you are not the victim of the circumstances.

    Scarcity: It would be a dream to see the world of endless abundance. But in reality, at any point of time, we have limited resources. The land, oil, and even the cash we have are limited and this scarcity makes us the need to choose. Markets and scarcity are closely related. The former would be rendered irrelevant and unnecessary in the absence of the latter. Assets increase in value in line with their scarcity. When scarcity decreases i.e., when demand drops or supply surges - asset prices collapse. The dotcom bubble was the result of this scarcity. Stock prices were driven by projected ever-growing demand and not by projected ever-growing supply of dotcom providers.

    Opportunity cost: Opportunity cost is defined as the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. For example you invest in a risk free bond yielding 5%, you gave up the opportunity of another investment - like equities yielding, say 10%. In this situation, your opportunity costs are 5% (10%-5%). Opportunity cost show variation among individuals, and between expectations. One person may perceive that an investment in a company will produce four times his investment in two years. Another person may expect only a doubling in two years. In fact, the stock may drop by half in two years. Retrospectively, both parties see the opportunity cost of not putting the money into a savings account as very large. Thus one has to invest according to one's need and risk appetite.

    Risks: the concept of opportunity cost comes along with risks. Every human endeavor carries some risk, and investments are no exception. Also not only does risk mean different things to different people, your own definition will probably change during your lifetime. What differs is the amount and type of risk and how you are compensated for taking it. In the above example, for a 5% higher return, the investor is taking the high risk of investing in equities. Here are three risk considerations you should review when planning your investments.

    • Time frame: Whether you are a long term or short term investor. Stocks and bonds can be volatile, especially in the short run. That is why, over the long run, your time frame is perhaps the most critical component in planning your investments. For example, if you are investing for a retirement that is 25 or 30 years away, you have time to ride out the ups and downs of the market

    • Inflation: One big risk most investors face is that their purchasing power will be eroded by rising prices in the future. "Playing it safe" and accepting no market volatility also means accepting the potential for lower returns - a risky strategy if you are trying to keep up with or even beat inflation.

    • Goal: This is the most important thing. The basis of investment depends on this. Once you know your goal, match your investments to it. If your goal is ambitious, you may have to accept higher volatility and a greater chance of loss in return for the potential to reap higher rewards. But if your goal is modest, you may be willing to accept the trade-off of less gain for lower volatility and less chance of losing your capital.

    Time value of money: this is defined as: the rupee I get today is worth more than a rupee I'm promised sometime in the future. The reason for this is that the rupee I get today is real, but the rupee I'm promised in the future will be worth less (because of inflation), Also, the money I get today can be invested to create more rupees in the future. On this ground, one can distinguish between the worth of investments that offer you returns at different times.

    Compounding: Albert Einstein rightly said, "The magic of compounding interest is truly the eighth wonder of the world!" Compounding is a simple concept that offers astounding returns: if you park your money in an investment with a given return, and then reinvest those earnings as you receive them, your investment grows exponentially over time. With simple interest, you earn interest only on the principal (that is, the amount you initially invested); with compounding, you earn interest on the principal and additionally earn interest on the interest. In other words, it's a way of making your money work harder for you, and is perhaps the most powerful tool that an average investor can use to plan for many of life's financial goals, including retirement.



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