The amount of money you have gives you purchasing power to acquire what you need or desire. It lets you pay bills, put food on the table and engage in leisure activities. Source of money can vary from person to person, it can be salary from your employer, allowance from your guardian, gains from business or assets and fees you receive for services you provide. Once you have taken care of basic necessities you are left with a choice of what to do with your surplus. You could keep the rest in an emergency fund, save it in a bank, invest in an instrument or move on to the next item in your planned expenditure which may not be a need but can be good to have or maybe a luxury item.
Decaying Value of Money
If you do budgeting and you are left with a decent amount of surplus after every month’s expenditure then comes the question of how to better keep this money safe for future use. You could keep this money in your house as cash but that is not at all a secure way to handle your investment is it ? It can be deposited in a saving account, it is secure now but is it keeping its value over time ? Money, if kept as is, becomes a perishable item. It loses its value over time if the average price of goods and services increases over time (inflation), which usually does increase. So a thousand bucks today may not be able to buy the same amount of goods in a year. Although savings accounts do pay some interest on the money you have deposited, they are usually less than the inflation rate.
Drawbacks of Liquidity
But why can’t they pay more interest ? The answer lies in the availability of your money to you and how your money is handled by the bank. Getting interest on your deposited money is basically growing the amount of money you have but it can’t happen just like that. The additional money you get every year or quarter comes from somewhere, for example payment done by someone while repaying a loan. But repayment of a loan takes time and if banks are giving away your money to other people then it might take a long time for them to repay. What if you need the money immediately and taking a loan when you already have money in the bank doesn’t make any sense. For this reason banks do provide the option to withdraw money from your check-in amount immediately, or give you the option to break a fixed deposit or recurring deposit account and give you the money. But that means banks have to keep certain amounts always available (liquidity) to handle such withdrawal requests and they can’t loan it out to earn interest payment.
Lock-Ins: Sending Money to Work
What if you know you won’t be needing the money for a long period of time ? If you have an emergency fund and a steady source of income you can say with a fair amount of certainty that you won’t be needing your deposited money for a foreseeable future. That gives you an opportunity to put your money in accounts where you can grow your money faster. There are options that let you do that but they put a restriction to not allow you to withdraw money for a long amount of time (lock-in period or maturity period). Money grows faster in such accounts, beating inflation, but you lose access to your money, retirement funds and tax saving fixed deposits are few examples of such instruments.
Why not both ?
What if you need the option of liquidity as well with such investment ? There are tradable bonds where you can invest, that let you sell your investment to someone else. Now the buyer of your investment will wait for the maturity period and you get the amount immediately although you do take a hit in the form of a discount you have to give to the buyer to make it worth their while.
So far we have discussed risk free investment where your money is always safe and you will always get the interest as promised, no more no less. Although, in some cases, you might have to lose some money if you need your money immediately. There also exist risky investment options, But why would anyone keep their money in a risky account and what does risk even mean ?
Risk & Reward
Risk basically means that there is a chance that you might not get the interest rate that was expected by the investment option and in some cases it also means that it can go negative, meaning you will lose your principal amount as well. So why do people even consider such options ? The answer is reward, in this case higher returns. Risk prone investments trivially give higher interest rates on your investment but why are these investments risky and how do they earn higher return.
What is Risk ?
Investment options are deemed risky if their interest rate or returns are determined by an uncertain entity. This entity can be market driven (like stock market) or maybe the risky loan issued against such investment. In case of a loan, if a lot of people default then the investment option won’t be able to sustain the return rate it was planning to give back to its investor. On the other hand, for market driven investment if the underlying entity loses its value over time the same will reflect in the return rate. Examples of such entities are, gold, real estate, stocks (value of company).
Still the question remains, why would anyone risk their money on such instruments ? The answer is, people usually don’t and when they do they don’t put all of their surplus money in risky investments. They diversify their investment and invest a percentage of what they have available into risky investment and rest in risk free investment options. So as to maintain a portfolio of investment options where some belong to risky and some belong to risk free. They monitor this portfolio to make necessary adjustments in the asset allocation to ensure maximum returns.
But how does one know the best way to do asset allocation ? This purely depends on one’s current financial situation and future liquidity needs. Your risk appetite is not just a personal choice but depends on how ready you are to take those risks. Also, your financial goals are not just what you want in the future but also what you will surely need to attain financial freedom. This requires planning and awareness of what all options are available and what you can afford at the moment.
What is Investment ?
Investment is making sure that your wealth doesn’t deplete over time and to prepare yourself to attain financial freedom. This process is unique to every individual but at the same time works on the same fundamental principles of time value of money and risk & reward. The steps are the same for everyone, self financial assessment, understanding and deciding financial goals, recognizing your investment biases, selecting most suitable investment options and then monitoring their performance over time. Seems like a daunting task but it doesn’t have to be, there are plenty of tools and services available to manage the same and if you are daring enough a simple spreadsheet might do the trick.