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What makes a successful savings plan
Kairav Shah | January 04, 2007
What is savings? Seemingly an easy question: we all have an idea of what savings is about. In common usage, saving generally means putting money aside, just as water flows through a pipe, cash flows through our wallets and purses. This flow is uneven.
However, some individuals have more cash flowing out than coming in, and, may, eventually go bankrupt because of it. If we manage this flow well, we will have more cash flowing in than going out - allowing us to place some aside and use it later.
As you begin to study finance closely, you will quickly learn about several principles of finance. These principles underlie virtually everything that you will study in finance as the subject.
They are surprisingly simple and easy to understand they are the cornerstones of our free enterprise system that we enjoy. Let's take a look to get a glimpse of what is involved.
The principles of successful savings plan:
Nothing happens without a plan
Nothing happens by chance, and everyone has a life plan that also determines the right time to leave Earth. So pay yourself first: although we may find it difficult at first, the key is to pay yourself first. It is a great way to get in the habit of saving.
Before long, you will be very happy that you are saving and paying yourself first, not last. A good rule of thumb is to save 10 per cent of your paycheck. If this feels too high, try 5 per cent for a while. Then, try to work up to saving 10 per cent of your earnings. You'll thank yourself over and over for doing it, once you've retired.
The magic of compound interest
Not all investing strategies are complicated. Perhaps the simplest strategy of all is to just leave it alone and let it accumulate over time, or "compound."
Thanks to the power of compounding, the more money you save, the faster it grows. That's because you earn interest not only on what you save, but also on the interest generated. The earlier you start to save, the more dramatically your money can grow.
The importance of liquidity
The term liquidity refers to how fast something can be turned into cold, hard cash (the kind you stick in your wallet). Liquid assets are those that are thought to be turned to cash immediately.
When seeking liquidity, there are several places you can stick your cash. They include, your house (hopefully well hidden), a savings account, a money market account or short-term certificates
Time value of money
An important principle in finance is the concept of time value of money: a rupee today is worth more to us than the same rupee in the future. There are 3 reasons why money has time value:
Pure or real risk free interest rate
We expect a reward for postponing spending, with a reward of additional rupees in the future. Otherwise there would be no incentive to save.
A rupee today is worth more than a rupee in the future since inflation will reduce the purchasing power of the rupee.
We would prefer a rupee today since in the future there is always a possibility of reduced payment or non-payment.
The risk-return tradeoff
A very simple statement: The higher the risk of an investment, the higher the expected return must be. In other words, the risk-return tradeoff says that invested money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio.
Diversification reduces risk
Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash.
One of the most important aspects of investing is the control of risk in your portfolio, relative to the expected return In building an investment portfolio, investors should avoid unnecessary risk through wise diversification.
Diversification is the allocation of investable funds to a variety of investments. By diversifying, investors can reduce the risk that they would otherwise bear.
The time dimension of investing
Over the shorter term, share price tend to fluctuate greatly and if you need to withdraw funds within five years, there is the risk that the value of your investment will have decreased.
However, it has shown that in the long run shares held for a minimum term of five years and you own a diversified portfolio, there will be low volatility then in the short term.
All risk is not equal
All risks are not equal - some can be diversified away, and some cannot be. The differences in risks or risk appetites can create a host of problems that need to be addressed, including the self-insured retention level, the level at which the stop-loss reinsurance kicks in, the strictness of underwriting guidelines, and so on. The same problems occur when one is attempting to form a group captive.
Taxes affect personal finance decisions
Our goal is not so much to minimise taxes but to maximise the after-tax. For example, Section 80L benefit has been withdrawn so actually rate of interest earned on the debt investment product would be low if we were taking the benefit under the section.
We can also plan to save on taxes for corporates, firms and HUFs, considering further deductions of 80D by taking a health insurance plan, and 80C by selective investments in insurance and home loans.
The author is head, financial planning division at Sykes & Ray Equities.