Key Investment Concepts

In the previous chapter, Ravi and Priya learned about the different types of mutual funds and their suitability based on risk and return. As Ravi prepares to make his first investment, Priya wants to ensure he understands some key investment concepts that will help him navigate the investing.

Risk, return, diversification, compounding, and liquidity are fundamental for any investor. In this chapter, Ravi will learn how these ideas shape investment strategies and help him make smarter decisions with his money.

The first thing to understand is risk. All investments carry some degree of risk, meaning you could lose money. Some investments, such as stocks, take more risk since their value can fluctuate. Bonds, on the other hand, are generally less risky. Understand your risk tolerance. Stocks are the way to go if you can handle ups and downs. But if you want stability, you may opt for bonds or other safer alternatives.

Another essential concept is return, which refers to the money you earn from your investment. This might be in interest, dividends, or asset value appreciation. Usually, the greater the return, the greater the risk. You must be prepared for more significant risk if you want higher returns. A bond might be a safer avenue if you wish for more predictable returns.

There's diversification, too. The bottom line is that it spreads money across available investments to decrease risk. For instance, if one invests in only one stock and it falls, he or she loses a lot. On the other hand, if you spread your money across stocks, bonds, or mutual funds, the risk involved in losing all of your money decreases. Diversification smooths out market highs and lows such that if some investments are performing dismally, others might perform well.

The power of compounding is one important concept here: this is the process whereby your investment earns returns, and those returns in themselves start earning their returns. Given enough time, compounding will make your money grow much faster. Suppose you invested ₹10,000 at 10% per year. Your money will keep on growing not only from the base ₹10,000 but also from the interest your investment has already earned. In such a case, starting earlier would help a person get the full benefits of compounding.

Another essential concept is liquidity. Liquidity is the ease with which you can liquidate an investment into cash. For instance, stocks or mutual funds are very liquid because they can be sold quickly. Other investments, such as real estate, take some time to sell. Knowing your liquidity needs is important, especially if you need cash suddenly.

Another thing to consider is inflation. That's when prices go up over time. If it's more than your return on investment, then your money decreases in real purchasing power. For example, if the inflation is 5% and your investment returns 3%, then you are losing money in real terms. That is why investing in assets that can outpace inflation, such as stocks or real estate, is essential.

Another key concept is asset allocation: how you distribute your money among asset types, such as equities, fixed income, and cash. Your asset allocation should be appropriate for your age, financial goals, and risk tolerance. If you are young and investing for retirement, put more in equities for growth. But if you are closer to retirement, you want to shift more into bonds for safety.

The last one is goals-based investing. That means you have goals you invest in, such as saving for a car, house, or retirement. Knowing your goals, you could devise an investment plan according to your needs. Suppose you are saving for a down payment on a house in a few years; in that case, you would want safer investments. But if you save for retirement in 30 years, you might take on more risk to shoot for higher returns.

Conclusion:

These seven key investment concepts, return, diversification, compounding, liquidity, inflation, asset allocation, and goals-based investing-are some of the building blocks to intelligent investing. And the more you understand them, the better equipped you will be to make decisions to help you reach your financial goals.

Armed with these principles, Ravi feels more confident about approaching his investments. But who exactly helps investors navigate these principles and make the right decisions? In the next chapter, we will dive into the critical role of fund managers, who guide and manage mutual funds to help investors reach their financial goals.