(This is from my Moneylife article published in the issue dated 28-09-2006) A primer on planning early for your retirement.
Here is a simple strategy to retire wealthy. The hard part is following it
Today, with starting incomes being fairly handsome, it is possible to have a nice nest egg when you are 50. You can retire early if you choose to, do something on your own or chase your dreams, provided you plan early. All you have to do is to take a fixed amount every month and put it away for a definite time horizon. Do not put away such a large amount that you will be tempted to use it before the time period is over. Save small amounts every month as a discipline. Think of this money as money that you would have spent at a restaurant. Let this minimum not change.
As your income rises, use the extra money to save for other things that you aspire. Even if you can save Rs 2000 every month from the time you are 25 till you reach 50 and assuming a minimal return of 10% a year, you will have over Rs 26 lakh at the age of 50! The amount you have invested is Rs 6 lakh (300 monthly installments of Rs 2000 each). Hindsight is a great thing. As I grow older, I realise that I should have started planning my savings and investments this way, much earlier in life.
Now, comes the question where to invest. I am a great believer in equities. If we believe that, on an average, our GDP will grow even at a rate of 7% over the next few decades, corporate profitability in nominal terms would increase by over 12-14% each year. Ultimately, this would get reflected in share prices. Of course, there would be terrible years in between, but since you would be buying every month, you will finally emerge as a winner. Investing in equities also addresses the taxation angle, assuming that capital gains would remain tax-free. What stocks to select? Assuming that this savings is the minimal amount we put away, the basic objective is to prevent erosion of wealth. I have three choices to recommend, the first one being my preferred one:
1. Choose an Exchange Traded Fund (ETF). ETF represents an index and indices typically include the largest companies that have a track record and reasonable survival prospects. Each ETF unit comprises all the stocks in the index it represents, in the same weight. More importantly, it takes away the decision-making aspect of which stock to omit and which to choose as the ETF automatically adjusts for changes in index components. The transaction costs are minimal and can be bought or sold like a stock. Pricing is real time. The one caveat is to avoid sector based ETFs and stick to a general index like Nifty or Sensex.
2. The second and inferior option is to choose a mutual fund scheme. Transaction costs are higher and the fund is vulnerable to the fund managers’ decisions. There is no guarantee that over a long period, a mutual fund scheme would outperform the index. Globally, it has not happened and there is no reason to believe that it will happen in India.
3. The third alternative is to invest directly in equities. You have to follow a strategy of investing once a year on a fixed date. Limit yourself to a few stocks (not more than 10), but you would have to do a lot of homework about choosing the 10 best and sticking to them over time, subject to periodic reviews. I would choose large established companies that I expect would be in business at least for the next 10 years. Having chosen them, I would divide my money equally among the 10, eliminating any personal bias.
This strategy may sound simplistic and unexciting but believe me, it is remarkably effective.