How To Create Wealth

Wealth creation is one of the most important goals for every investor, and it is definitely not rocket science. Investors need to plan well to achieve this goal, says Hemant Rustagi

Creating wealth is a process that requires an investor to start investing early, invest in a disciplined manner, remain committed to the process through the defined time horizon and build a portfolio that has the potential to earn a positive real rate of return. In reality, however, many investors invest in a haphazard manner. Often, they get overwhelmed by panic and anxiety and abandon their investment process.

To become a successful investor, one needs to have an investment plan in place and the conviction to stick with it during periods of market turbulence. Remember, a sound investment plan must take into consideration factors such as one’s current financial situation, investment objectives and attitude towards risk.

In fact, understanding the various risks associated with one’s investment process is extremely important. While most of us equate risk with the potential to lose a part of our capital, there are also other risks like inflation that don’t allow the money invested to grow in real terms.

Besides, investors would do well to remember that risk is an inherent part of investing, and that there is a direct co-relation between risk and reward. The level and type of risk would depend on one’s time horizon, i.e. the length of time one has to achieve one’s investment objectives.

For a short-term investor, volatility is a bigger risk than inflation. Therefore, a short-term investment strategy should focus on capital protection through a portfolio consisting of interest-bearing securities. Inflation is a far bigger risk for a long-term investor. Therefore, the real rate of return, i.e. returns minus inflation, becomes crucial in determining the level of success one can achieve. Besides, consistency in the investment process helps one benefit from compounding.

As is evident, the key to investment success is to find and maintain one’s balance at a risk level one is comfortable with. Investors often make the mistake of overestimating the returns/underestimating the risk associated with an investment. Different types of investments have different levels of risk, and one should expect returns commensurate to that.

Another important aspect of investing is diversification. This not only reduces the risk in the portfolio, but also allows it to perform in different market conditions. Asset allocation is a form of diversification that reduces the portfolio’s risk more than it compromises returns. When one invests in two or more asset classes that tend to go in divergent directions in different market conditions, the combination is likely to have a stabilising effect on the portfolio.

Unfortunately, diversification is also an aspect of portfolio building where a number of investors end up making mistakes. The common belief is that the more number of funds one invests in, the more diversified the portfolio is. This is a myth that investors have been following for years. On the contrary, a portfolio that suffers from over-diversification may see its returns getting diluted as the non-performing funds pull down the overall returns. Moreover, the portfolio becomes unduly complicated and thus difficult to track.

Investors need to realise that MFs themselves are a diversified investment vehicle. For example, most multi-cap equity funds would have 40-50 stocks in their portfolio, and hence, the money gets diversified into a number of stocks, a number of industries and a number of segments. Therefore, investors need to look at diversification from the wider point of view of the portfolio of the funds they are invested in and not from the limited perspective of their own portfolio.

Time diversification, i.e. remaining invested over different market cycles, is another factor that is particularly important for equity investors. This helps in mitigating the risk that one may encounter while entering or exiting a particular investment or category at a bad time in the economic cycle. It has much more of an impact on investments that have a high degree of volatility, such as equity or equity-oriented funds. Longer time periods smoothen out those fluctuations. Time diversification is also important while selecting the right option from among stable investments such as short-, medium- or long-term debt funds as well.

Remember, one’s time horizon begins when one invests and ends when one needs to take the money out. The length of time one remains invested is important because it can directly affect one’s ability to reduce risk. Longer time horizons allow an investor to take on greater risks with greater potential to earn better returns, as some of the risks can be reduced by investing across different market environments.

Hemant Rustagi
CEO, Wiseinvest Advisors