Anyone looking to build personal wealth knows the pivotal role investment plays in achieving that goal which most often is around getting that high rate of return. Experts suggest that a general rule of thumb is buying low and selling high. Although sound advice, it might be difficult for a novice to understand why.
On the other hand, beginners often tend to buy high and sell low. That is, they invest in an asset when the market is doing well, and when the market skews to lower rates, they panic and sell or liquidate. They employ the rationale that if the rates are high, they could make a quick buck on their investment.
Many investors are left confused with miscellaneous advice from various sources vis-a-vis investment. They intuitively gravitate towards a high rate of return. The question then is, is a higher rate of return enough to achieve your financial goals or for building wealth?
To answer this question, we must first understand some important terminology used in investment and its function. Let’s start with the Rate of Return or RoR.
RoR is the measure of net profit or loss of an investment over a specified time. When the investment is made for longer than a year or if there is a reinvestment, the RoR is calculated as Compound Annual Growth Rate or CAGR. CAGR takes into account the compounding effects on the initial investment. CAGR can thus provide a clearer picture of the performance of your investment. Real Rate of Return offers an even more accurate picture of your investment by taking into account the effects of taxes and inflation on your investment.
We need to understand that all these kinds of RoR are calculated retroactively for individual investments. When you invest in mutual funds, equity mutual funds, shares, hedge funds, or any other asset that is subject to market risk, the calculations you make vis-a-vis the value of your investment and your profits are based on historical averages and thus only speculative.
Thus, a high RoR isn’t the primary factor you should rely on when investing. It is particularly true if your goal is to multiply your initial investment. This can be illustrated if we compare two people’s investments.
Take person X, who invests ₹ 5,000 for a period of 3 years, and at the end of 3 years, the value of the investment is ₹ 15,000. The CAGR for person X would be 44.22%.
Person Y invests ₹ 4,000 after waiting for the market to stabilize. But as there is a drop in the market, they withdraw the investment after 2 years. The value of their investment at that point is ₹ 10,000. The CAGR for person Y would be 58.11%.
Even with the high rate of return, or CAGR of person Y, the wealth they accrue is lesser than person X. The obvious takeaway is that higher RoR may not always result in a higher investment value. Being consistent and patient may lead to better results.
Another possible factor that may have affected person Y’s investment is their reluctance to start investing immediately. Often the best time to start is ‘right now.’
Given the fluctuations in the market, the best method to generate higher wealth is consistent and disciplined, long-term investment strategies. The cycles of growth and fall in the market can be highly unpredictable. Relying on averages, even in the case of conservative estimates, is not prudent.
The portfolio allocation should be such that you do not solely rely on market-dependent asset classes to generate wealth. An alternative is fixed-income assets such as bank fixed deposits, public provident funds, or systematic deposit plans. Fixed-income assets are not subject to market risks and provide steady growth in your investment at a fixed rate. These are predictable and risk-free options, but the downside is that the rate of interest they offer could be low, and the returns might not be as high as you’d like.
Many investors rely on the performance of the market to start investing and managing their investments. Generally, people avoid investing or withdrawing their investments when the market is high. Such a heavy reliance on the market may not be the wisest decision. Neither is it prudent to prioritize high rates of return to build wealth.
Wealth creation works best when you have a diverse portfolio that minimizes the risk profile. Additionally, a well-planned and consistent investment strategy will pay off better, resulting in a high rate of return i.e value of the investment in the end.
Don’t wait until it’s too late.
Start today and secure your future.