Simple rules of investing

Just like any sport, there are some simple rules to keep in mind while investing. These A-B-Cs would go a long way as guiding light in an investor's life to build his/her long term wealth.

Rule #1: Which one comes first - Expense or Savings?

Most of us learn to spend and save like our parents. Bring home an income, spend on expenses and then save the remaining. The equation takes the form:

Income - Expense = Savings

While this approach looks perfectly practical, the nature of this savings is volatile depending on lifestyle choices one makes. Certain choices could also result in zero or negative savings, leaving nothing for the future. One approach to long term wealth creation would be to make a simple change to the equation as follows:

Income - Savings = Expense

In this approach, the nature of savings is fixed and stable through out the income earning phase of the investor. Another big advantage here is savings rise along with income levels through the income earning years.

Rule #2: Simple interest or Compound interest?

Savings when invested can earn two types of interest - we have studied in school about both forms of interest. To recap:  
Simple Interest: P * n * r
P: Principal
n: Tenure
r: Rate of interest

Features of Simple Interest:

• No capital appreciation, Rs.1Lac stays as Rs.1Lac at the end of say a 10 year tenure.
• Provides regular interest payouts (monthly, quarterly or annually).
• Money loses its value in 10 years due to inflation.
• Best suited for distribution phase of one's life, eg. retirement.

Compound Interest = P * (1+r)^n
P: Principal
n: Tenure
r: Rate of interest

Features of Compound Interest:

• Provides capital appreciation over the investment horizon, Rs.1Lac becomes Rs.2.15Lacs at the end of say 10 years investment tenure in a bank term deposit @ 8% interest p.a
• Beats long term inflation - money either stays or grows in real value.
• Best suited for accumulation phase of one's life, eg. income earning years.

Rule #3: Am I buying an Asset or a Liability?

In all your purchases, be sure whether you are buying an asset or a liability. You may ask, how could you be sure? To be sure, we need to understand the defining criteria that clearly classifies a product as an Asset or Liability.

Criteria for Asset: It is one which after paying up, appreciates in value (eg. Gold) or generates income (eg. Rental property).

Criteria for Liability: It is one which after paying up, depreciates in value (eg. Car) or continues depleting your income (eg. ULIPs)

One needs to understand that these are not hard and fast rules and there is nothing good or bad about making these choices. We still need to make certain life choices to enjoy life's comforts such as buying a car or possesing that wedding solitaire. Nevertheless, if one is focused on creating long term wealth, keeping in mind these simple rules would help them achieve their financial goals in a realistic manner.