Personal Finance

Take the easier path to wealth creation

Suresh Parthasarathy | Updated on January 31, 2011 Published on January 09, 2011

Here are four tenets to guide you in your pursuit of wealth and help you avoid some typical mistakes in strategy.

Most salary-earners believe that wealth-building is only for the ultra high-net-worth individuals. After all, doesn't money beget money? However, wealth creation is really not just for an exclusive club of ultra-rich individuals. Anyone can build wealth through planned investments over a long period of time.

However, unless you have strategies in place you are leaving wealth creation to chance. The fact that ultra HNIs achieve higher returns than middle-income individuals owes a lot to their asset allocation pattern. There may be several strategies to build wealth. However, we draw on real-life examples to arrive at four basic tenets that will guide you in your pursuit of wealth, even as you avoid the cardinal mistakes some people commit.

Invest based on life cycle

Most people tailor their investment and savings habits to the experiences of others. Take Rajesh Mariappan, an IT professional in his late twenties, who reveals that since his father lost quite a lot of money during the stock market correction in 2000, he himself never invested in equities!

The fear factor made Rajesh opt for an ultra safe portfolio, with all his savings in debt investments earning an average interest rate of about seven per cent per annum. Inflation and taxes have since whittled down these returns to nothing, with the result that Rajesh has been saving diligently, but has built no wealth in the past six years.

Individuals should base their investment preferences on their own life stage. Investors in the age group of 20 plus can take higher exposures to risky asset classes such as equity compared to those in their late 50s, because they have the ability to wait out any market corrections. Those having a long working life ahead of them with financial goals 10-15 years ahead should include equity in their portfolio. Due to the compounding effect and lower taxes compared to pure debt investments, equity can help one build wealth at a faster pace.

So this is Rule 1: Investment strategies should be tailored to one's needs.

Know thy risk

Risk-profiling is the first step towards asset allocation. Each asset has a different risk profile and the investor needs to understand and choose from among options based on his own risk appetite. Having chosen a particular option after understanding the risks, one should avoid changing the allocation unduly because those risks actually materialised!

Many individual investors, for instance, booked profits in stocks after the initial run up in this bull market and have not been able to re-enter market at prevailing prices due to a dilemma about whether the market is too risky to enter. Now, investors with a 10-year horizon and keen on building wealth should not drastically reduce their equity exposure on small market blips.

Take the case of Bangarappa, who holds a business administration degree. On the advice of his broker he promised his father that he could double his retirement money in the short term by investing in derivative instruments. He invested the entire Rs 16 lakh of his father's retirement proceeds in late 2007 in stock futures. When the market crashed, his portfolio was worth just Rs 3 lakh, effectively decimating his father's savings and jeopardising his sister's marriage. While equity investments or derivative exposures may be suitable for people with a high-risk appetite and a big surplus to spare, they certainly aren't a parking ground for retirement savings.

Being over-cautious can have its pitfalls too. Mutual funds are meant mainly as long-term investment options. But in 2010 retail investors have continuously withdrawn money from such funds on every rally. Having withdrawn Rs 17,000 crore from MF equity schemes while market was rising, they may have lost out on an opportunity to make the best of the rally. Ultra HNIs and foreign institutional investors, on the other hand, continued to pump in fresh money and made big gains in the rally. This explicitly shows that if investors don't understand the risk implied in their investments, they may move in the opposite direction of the trend and fail to build wealth.

Rule 2, therefore, is: Be comfortable with the risks before investing in an asset class

Know where to use leverage

In an easing inflation scenario, leverage can help build wealth quickly. However, investors should be cautious in knowing where to use debt and how much leverage to take. Salary earners often fail to make a distinction between using leverage to buy “lifestyle” assets and appreciating assets.

Lifestyle assets such as an owned home, car, a plasma television or other electronics gizmos may improve your quality of life, but they do not help build your long term wealth. Wealthy people may create lifestyle assets by liquidating other investments, but salaried individuals borrowing to fund these buys may be saddled with large EMI repayments for several years at a time. That precludes investment in other appreciating investments such as shares, debt or even rental property. A decade ago the average age of the individual taking a home loan was 40-plus, whereas this has dropped to 30-plus today. That suggests that investors commit a large part of their earnings to a home loan repayment very early in their career. Investors paying 50- 60 per cent of their gross salary as EMI may, due to limited surplus failed to invest sufficiently in stocks, mutual funds or other appreciating assets.

Take the case of Chennai-based young couple Sathish and Priya, in their mid-thirties, who bought who their first house five years back and then added on a Rs 20-lakh plot of land five years later. While the home is self-occupied and the land may yield appreciation over the long term, their investment plan suffers from a key defect. Both their investments are leveraged and take away a good portion of their monthly earnings. More important, both their investments are in a single asset class — property. If property prices were to grow very slowly over the next 10 years that would certainly impact their wealth. Over-exposure to one asset class can be a hindrance to their wealth building exercise if equities or debt outperform over the next 20 years.

Thus, Rule 3: Unplanned debt will eat away growth

Diversification

No asset class is guaranteed to deliver uniform returns from year to year. The key benefits of diversification are that even if one asset class underperforms in a specific year, the others will make up for it. So, the secret to building wealth with reducing risk is diversification. For instance, in the last five years, equity, debt, real estate and even crude oil all witnessed a bumpy ride; gold is the only asset class that has delivered a consistent return from year to year.

A bit of gold in your portfolio may have helped even out the bumps while the stock market crashed or interest rates fell. However, what percentage of the portfolio should be allocated to each of these assets is based on the individual's risk appetite. One common mistake individuals make is, however, in diversifying too much within the same asset class.

Raghavendar, a businessman, has an equity portfolio of Rs 15 lakh. With mid-cap stocks rising last year, he took a further Rs 5 lakh loan by pledging his shares and invested this sum in mid-caps too. In November, his mid-cap portfolio had lost 30 per cent. He now faces a double whammy where he needs to pay interest on his loan and also suffer portfolio losses. Many investors own more than a dozen equity funds in their portfolio. Now that leads to duplication of stocks and may not materially lower the risk, even as it increases your hassles in tracking your portfolio.

Rule 4 says: Don't put all your savings in one asset class. Always keep room for a surplus to diversify

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