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While making the list of groceries for the month, most of us tend to keep aside a higher amount every month because prices of all goods have gone up. Similarly, when our five-year bank fixed deposit (FD) matures this year, it will not give us the same value it would have at the time of investment, even though the maturity value is higher than investment. Eroding the value of your investment or money is inflation. While you have read and heard about inflation increasing and decreasing in news reports, you are not really sure how it really works.
A recent study by Standard & Poor's Ratings on financial literacy showed 76 per cent of Indian adults do not understand key financial concepts, including risk diversification, inflation and compound interest. Given the weak financial skills, it is a question of whether investors are getting the most out of their money, the survey said.
According to Supreet Bhan, executive director, head of retail sales at J P Morgan Asset Management, the issue is not lack of knowledge, but the attitude of the Indian investors who demand instant gratification and value for money. “While this attitude is fine in case of buying a good, such as a mobile phone, it does not work in case of financial investments, which are non-tangible. In this case, the key is long-term investing,” Bhan points out.
While investing in debt products such as a bank FD, investors know the rate of interest upfront. So, they know what the returns are likely to be. But in case of market-linked products, there is no certainty at the time of the purchase and this leads to confusion.
Since market-linked investments are a relatively newer concept, compared to small savings schemes such as Public Provident Fund or bank FDs, investors must be willing to wait it out for the long term to understand the true meaning of compound returns. Often, this is a challenge.
Tanwir Alam, chief executive of Fincart, investors are aware of concepts such as power of compounding or inflation, but they don't really understand how it really works. “For instance, in case of compound interest, investors must realise that it applies not only in case of assets, but also in case of liabilities. That is why credit card or personal loans are expensive,” he points out.
Indian investors were always open to physical asset classes such as gold and real estate. But, seeing how both these asset classes have not been doing well in the recent past, investors have got a first-hand experience of risk diversification.
“People base their investment decisions on past performance, but that is flawed logic. Performance of asset classes will change every year,” says Bhan. Not investing is far riskier than the risk of investment, points out Alam. For instance, the Sensex which was at 3,000 levels in 1999, is 26,000 now. In the interim, it fell from 21,000 to 8,900 in 2009. “The Sensex has given returns in excess of nine per cent on a compounded annualised basis, despite the sharp fall. Those who remained invested over this period have made more returns than those who did not invest at all,” says Alam.
It is important for investors to at least appreciate, if not understand, the key financial concepts. “Today, financial products are getting more complicated. You can no longer just invest in bank FDs, which are a safe investment because due to inflation, you will be poorer 10 years down the line even if your income is the same. Also, understanding financial concepts helps you identify what you need to know and what you don’t. The risk of not knowing is too much these days,” says Malhar Majumder, partner and consultant at Positive Vibes Consulting and Advisory.
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