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Aug 27, 2012, 05.35 PM IST
Lack of understanding about different investment brakes like costs, taxes and too much caution can slow down your investment's success. Financial advisor Amit Trivedi advices us to consider these brakes while making any investments decision to maintain a healthy portfolio.
Few years back, I had heard this nice joke about two friends going on a bicycle ride. While the one seating in the front seat (let's call him Ram) was handling the governor, the one on the hind seat (we'll call him Shyam) was pedaling the cycle. The bicycle was navigating smoothly through the city traffic. The coordination between the two was good.
Then came a slope that they had to climb. It was little too steep for the bicycle with two riders. Shyam started pedaling harder and harder. He was huffing and puffing. By the time they reached the top of the slope, he was fully exhausted. Catching his breath, he said, "This is the steepest and most difficult slope I have come across in my whole life". Ram replied, "Just imagine what would have happened without my help". Shyam wondered what help did Ram do. Ram said, "The slope was so steep, we could have gone backwards, if only I had not held firmly onto the brakes."
Well, this is what we regularly observe when investors share their experiences. While they are huffing and puffing up the slope to move ahead towards their financial goals or financial well-being, they are not aware of certain brakes being applied.
In our example, the riders had to cover a short distance going up the slope. Imagine if someone had to climb up the Mount Everest with the brakes applied. In the world of investing, it's a life long journey of riding the bicycle up the slope. This slope is known in the world of Economics and Investing as "inflation". This is the rate at which prices of consumption items rise up. The investments' ability to generate income has to keep pace with this rise in general level of prices. That's why we took the example of a life long journey of going up the slope.
Let us now understand some of these brakes. The three types of brakes are: costs, taxes and too much caution.
If the costs of investing are high, the returns come down. Taxes also eat into the return on investment. Both these reduce the speed of the bike and thus the effort required to go up would be more.
These two are easy to understand, but the third one, too much caution, is often not realised by the investors. It is like our example of two friends. Shyam did not know that Ram had applied the brakes, which meant his efforts had to be increased. Indians, in general, are averse to the risk of equity investing. This is not so much about the risk-return trade-off that the investment avenue offers, it is about lack of understanding and poor planning of one's finances.
Most lack understanding of equity as an asset class as well as the risks involved in all the other investment options. While equity is a risky asset class, it has the potential to beat inflation over various periods. However, most investors focus on the short term price fluctuations exhibited by equity and prefer to stay away from it. In the bargain, they give up the ability to beat inflation over a longer period of time. There have been enough studies to suggest that among all asset classes, it is equity that has a better chance of delivering above inflation returns after taxes. Beating inflation is the only way to creating wealth over a period of time.
Understand the risks; understand the brakes that one may be unknowingly applying.
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