Stay On Course To Create Wealth

Creating wealth is an important goal for all of us. However, many of us err while making investments for this very important goal. While some of us make the mistake of investing predominantly in conservative and inefficient investment options, there are those who invest in a haphazard manner. In reality, creating wealth is a process that must be started early and pursued in a disciplined manner. Besides, one must remain committed to the process through one’s defined time horizon and have an asset mix that has the potential to earn positive real rate of return.

Considering that wealth creation is a long-term goal, one has to face several challenges during this ongoing process. In fact, it often tests the resolve of even those investors who initiate their wealth creation process after careful planning. As a result, they feel compelled to abandon their investment process. If you are in the midst of your investment process or are looking to initiate it, you must remember not to panic during turbulent times.

It is equally important for you to understand various risks associated with your investment process. While most of us equate risk with the potential to lose a part of our capital, there are risks such as inflation that don’t allow our money to grow in real terms. Besides, it would help you to know that risk is an inherent part of investing and that there is a direct co-relation between risk and reward. The level and the type of risk would depend upon your time horizon i.e. the length of time you have to achieve your investment goals.

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Remember, when you invest for short-term, volatility is a bigger risk than inflation. Therefore, your short-term investment strategy should focus on capital protection through a portfolio consisting of interest-bearing securities. Similarly, inflation is the biggest risk when you invest for the long term, as it eats into your purchasing power. Therefore, the real rate of return i.e. returns minus inflation becomes crucial in determining the level of success you achieve after your defined time horizon.

As is evident, the key to investment success is to find and maintain the balancing at a risk level you are comfortable with. Don’t make the mistake of overestimating returns or under-estimating risk associated with an investment. You need to be careful about this aspect of investing as different types of investments have different levels of risk and you should expect returns commensurate to that.

Another important aspect of investing is diversification. Diversification is important because it not only reduces the risk in your portfolio but also allows it to perform in different market conditions. Asset allocation is a form of diversification that reduces your portfolio risk more than it compromises returns. When you invest in two different asset classes that tend to go in opposite directions in different market conditions, the combination is likely to have a stabilizing effect on your portfolio.

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Unfortunately, diversification is also an aspect of portfolio building where many of us end up making mistakes. The common belief is that more the number of funds one invests in, the more diversified the portfolio is. It is a myth that investors have been following for years. On the contrary, in a portfolio that suffers from over-diversification, the returns get diluted as non-performing funds pull down the overall returns.  Moreover, the portfolio becomes quite complicated and it is always difficult to keep track of a complicated portfolio. You need to realise that mutual funds themselves are a diversified investment vehicle. For example, most multi-cap equity funds would have 40-50 stocks in the portfolio and hence the money gets diversified into a number of stocks, a number of industries, and a number of segments. Therefore, you need to look at diversification from the point of view of the portfolio of the funds you are invested in and not from the point of view of your own portfolio.

Time diversification i.e. remaining invested over different market cycles is particularly important for your equity investments. It helps in mitigating the risk that you may encounter while entering or exiting a particular investment or category at a bad time in the economic cycle. Time diversification is also important even while selecting the right option among stable investments such as short-term, medium or long-term debt funds as well.

Remember, your time horizon begins when you invest and ends when you need to take the money out. The length of time you remain invested is important because it can directly affect your ability to reduce risk. Longer time horizons allows you to take on greater risks with a greater potential to earn better returns as some of the risks can be reduced by investing across different market environments.