Investing is about using your money to make more money. You could invest by buying different financial assets and financial instruments that have the potential to appreciate in value over time. These benefits could be in the form of rise in value of the asset or instrument or a time-to-time payback from the investment.

There are many different financial assets and instruments in which you can invest money for it to grow in value. So, when you put Rs 10,000 in the bank and it earns 3% returns annually; your deposit of Rs 10,000 becomes Rs 10,300. Likewise, it is possible that your investment in the stock of a listed company at Rs 120, it may go up to Rs 127 two weeks or six months after you make the investment. The growth in value of the investment depends on several factors and the time the money you invested stays invested.

What is investing?

Savings is a simple concept wherein you set aside money for a specific period of time in an instrument that pays out a fixed interest on the saved sum. For instance, money that you put in a bank deposit or savings account pays out a fixed interest for a defined time.

In contrast, investing does not guarantee any returns, and the sum that you put in could even go down or go up in value over time. However, in the long term, investing across asset classes has proven to appreciate value of your invested money.

How investing differs from savings?

Returns indicate the gain or loss on your investment. And, the rate of return is the percentage decrease or increase over your initial investment. Suppose you invest Rs 1,000 and it appreciates to Rs 1,500; the simple return on the investment would be 50%. In this example, we are not considering the time taken for the investment to gain.

To understand the impact of time on the returns, you need to understand compound interest, which is basically interest earned on interest over a specific time. For instance, 5% annual interest over Rs 100 invested for three years would earn 5% interest each year.

Understanding returns

There are several avenues to save and invest to earn real returns. These avenues are known as asset classes as well as financial instruments in which you can invest. For instance, you can invest in stocks or mutual funds and save money in a bank account or deposit.

The different investment options through different financial instruments provide you the choice based on your risk taking capacity when investing. For instance, there are financial instruments which are considered to be safe like bank deposits for the guaranteed returns one earns on the money kept in it. Then there are stocks in small capitalise companies, in which investments are highly volatile with stock prices going down and up each day.

Where can I invest?

Think of asset classes as nutritional components in&nbsp;a diet &ndash; fats, proteins, carbohydrates, vitamins, minerals and water. There are different food items like fruits, vegetables and grains etc which contribute to the essential nutritional component independently and collectively. Many of these have similar characteristics, yet they are unique in their individual capacities as well and serve different purposes.

Asset classes are similar &ndash; they are a group of similar investment instruments. Different types of financial instruments are grouped together based on their similar financial structure. Just the way citrus fruits include oranges, grapefruits, mandarins and limes or stone fruit include apricots, peaches and plums. Similarly, when it comes to investing; equity, debt, commodity and cash are primary asset classes.

Different asset classes

Compared to savings, investing is risky and is yet important. The reason being; though savings offer guaranteed returns; the gains are not enough to retain value of money because of inflation. PricesPrice of goods and services mostly rise with time, which means the price of 1 litre&nbsp;of milk or 1 kg of rice changes a year later because of the impact of inflation.

If left unchecked, inflation eats into the worth of your savings, by shrinking the value of money over time. It is for this reason that investing is important to beat inflation and earn returns that are greater than inflation to retain and grow the value of money.

For instance, the worth of Rs 1 lakh in 1990, if left as it is, that is it doesn&rsquo;t earn any returns, would be worth Rs 15,626 at 6% annual inflation in 2020. And, the inflation adjusted value of Rs 1 lakh in 1990 would be worth Rs 40,101 or only worth 40% of its value.

Why is investment important?

Real return is what your investments earn after factoring in inflation and any other factors such as tax.

Real Return = Nominal returns - inflation rate&nbsp;

Real Return = 10% - 6% = 4%

Assuming 6% annual inflation and 10% annual return from an investment

The real return is an important factor to know when investing because collectively both inflation and taxes eat into the worth of your investment. As an investor you should understand the concept of real rate of return to invest in instruments that will have a positive real return, based on the risk with the investments that you can take.&nbsp;

So, the real rate of return is the annual percentage return on an investment, which is adjusted to inflation and any other factor. So, Rs 1 lakh earning 10% return when adjusted with 6% inflation and 20% tax; works to Rs 1,01,697.5, and not 1,03,773.5, which would be a simple inflation adjusted return.&nbsp;

Real returns = Nominal returns &ndash; (inflation + tax)

Real Return = 10% - (6% + 20% X 10)&nbsp;

Real Return = 10% - (6% + 2%)

Real Return = 2%&nbsp;

Assuming 6% annual inflation, 10% annual return from an investment and tax at 20%

What is real return?

All forms of investments include some degree of risk. Risk is the factor that could result in a potential loss of investment in the price of instruments such as stock, mutual fund, bond etc. Each type of investment is exposed to some degree of investment risk, for instance, even the guaranteed return on bank savings account of 3.5% is subject to risk of inflation which erodes its real value over time. Every financial instrument has a different return potential based on the risk the investment in it carries. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

What is investment risk?

Market Risk -&nbsp;How the market in which the financial instrument functions. For instance, stock market movement is based on economic factors, interest rates, currency rates and even news among others

Liquidity Risk -&nbsp;It is the time taken to take out your investment in an asset. For instance, money from bank account can be taken fast, but that may not be the case when it comes to selling a house

Concentration Risk -&nbsp;It is the risk of investing significantly in a single investment. Like putting over 80% of your savings into equities or debt instruments

Credit Risk -&nbsp;This applies to investments in bonds, where the risk is on default on the bond issued that is non-payment of the invested money

Inflation Risk -&nbsp;The risk that your investment earns a return which lower than what the prevailing inflation rate is. For instance, at 6% inflation and 3.5% interest from bank savings account; your real return depletes the value of the savings.&nbsp;

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Different types of investment risk

As an investor you need to know the different types of risks your investments are exposed to because that will help you clearly spell the investment risk that you can take. Knowing your risk tolerance is critical to where and how you invest and a strategy that you follow with your investments. Think of risk tolerance as your willingness to lose the value of your investment for the potential higher gains.&nbsp;

Risk tolerance is also a factor that changes with your age, income, investment knowledge and experience, marital status, and other factors such as family circumstances and stage in life.

Aggressive investor:&nbsp; Willing to use high-risk investment instruments in the quest for higher returns.

Moderate investor: Looks for a balanced portfolio by spreading investments across asset classes that can collectively help with growth and stability.&nbsp;

Conservative investor: An investor who is willing to accept lower returns for the safety of the invested capital.

Importance Of Investments

What is investing?