How investing wisely can build long-term wealth

Nassim Nicholas Taleb famously quoted, "When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns - in short, being fooled by randomness." Our primary goal as an investor is to allocate our financial assets in such a way that they remain secure and provide us with returns that adequately cover our long-term goals and aspirations. As an individual goes through various stages of life he or she needs to provide for various goals like buying fixed assets (house and car), providing for children's education, retirement planning and many others. Since the cash outflow for most of these is likely to be substantial, it is important to invest regularly and in a disciplined manner over a longer period of time, to achieve these goals. The benefits of investing for the long term are myriad.

Get the power of compounding to work for you

Compounding is a beautiful concept which truly gets your money to work for you. Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. Simply put, it is earning interest on interest. For example, Rs 100 invested at 10% interest will generate Rs 110 in one year. Now in the second year the investor will earn 10% on the original Rs 100 that he invested as well as on the Rs 10 that he earned in the first year. So total earnings for the second year will be Rs 121. Following a similar principle in the third year, the investor will earn on the original Rs 100 and the Rs 21 earned by him over the previous two years, taking his investment to Rs 133. Thus it is evident, the longer term that we invest our money for, the harder our money works for us.

Allow "rupee cost averaging" to minimise the importance of timing

Economies and markets go through cycles, making it difficult for investors to predict the peaks and troughs. Timing the markets in terms of the "best time to invest" is an extremely challenging task. "Rupee cost averaging" protects an investor from the risk of investing all his money at the wrong time by following a consistent pattern of adding new money to investment portfolio over a long period of time. By making regular investments with the same amount of money each time, you will buy more of an investment when its price is low and less of the investment when its price is high. One can also opt to invest in Systematic Investment Plans (SIPs) offered by mutual funds, which work on a similar concept.

Provides the investor with the option to rebalance his or her portfolio to reflect changing ability to absorb risk

Since the investor has built the portfolio for a long period of time, it gives him the flexibility to rebalance the portfolio to reflect his changing ability to absorb risk. As an investor ages, exposure towards equities should ideally reduce and exposure to fixed income instruments should increase, in order to provide stability to the portfolio.

Reduces variability or risk of the portfolio

Long-term investing helps smooth out the variability that arises from market volatility and accordingly helps reduce portfolio risk.

Having gleaned the benefits of long-term investing, it is now imperative to understand how such a strategy can be executed.

Draw a personal financial map and evaluate your comfort zone in taking risk

The first step towards successful long-term investment is to draw a financial road map highlighting your long term goals and evaluating your ability to absorb risk. An investor's various goals usually coincide with certain points of time on his life cycle and reflect changing levels of risk tolerance. Investing long term should reflect the investors' changing return requirements along with risk tolerance.

Adopt a disciplined approach and invest regularly

The investor should adopt a disciplined approach and start investing his money from an early age. The investor should invest his funds regularly and adhere to the principles outlined in his long term financial plan. It is also imperative that the financial plan should be evaluated periodically to reflect the investors' changing circumstances, if any.

Diversify your investments across asset classes

It is important to diversify your portfolio across various asset classes, financial instruments, sectors and geographies. Diversification helps minimise the portfolio risk as often losses from a certain asset class are offset by gains from another asset class.

Seek professional advice or invest with professional asset managers like mutual funds

Mutual funds are professionally managed funds that help an investor diversify his funds across asset classes and achieve his financial goals. By investing through mutual funds, an investor gets the benefit of having his money managed by investment professionals who are strictly regulated by the Securities Exchange Board of India (Sebi). Mutual funds also offer various products in both the debt and equity segments, thus giving an investor the opportunity to choose investments that suit his risk tolerance and financial needs.

The writer is fund manager, equities, BNP Paribas Mutual Fund.