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Capital erosion and your savings can never get well along. To secure your money, reallocate your asset investments. To know more, check out this article!
As kids, we all have come frequently across the term erosion. The meaning is simple- the gradual decline in the state of something.
So, just as soil erosion signifies the decay of soil quality, capital erosion signifies the negative impact on the sales, profits, or assets of any organisation that happens over time.
In finance, erosion is a long-term phenomenon. Therefore, its effects are slow but significant. In case you are considering your personal cash management, erosion does play a role in determining your financial well-being in the long run.
Actually, capital erosion is the prime risk factor that has to be taken into account while making investment decisions. Where you invest and how much time you spend within one asset class is the main rationale behind a successful investment.
Just like how the situation is for any business, erosion can have a negative impact your personal savings too.
What to do if erosion can destroy our investments just like that? Asset allocation.
One thing that you will need to do to secure your savings and investments is to pick the right asset class. As an investor, you must know that every asset class has its own phase of highs and lows. That's why you need to balance your portfolio with high risk and low risk investments.
With different risk-return profiles, a diversified investment portfolio is the only way to manage your savings in the best way and ensure optimised returns.
How Can Capital Erosion Decay Your Finances?
Capital erosion happens over time. Generally, it majorly affects the health of your assets. If you run a business, you need to be extra careful. The reason being, your profits, assets, and sales- are all threatened by capital erosion.
If you know the effects of inflation on your cash, then you can understand capital erosion.
Inflation and capital erosion are similar- they harm your saving plans. The cash that you are storing will lose value, the property that you buy will lose its value over time, and the equipment or machines that you possess will soon depreciate-both in terms of efficiency and value.
All these negative things happening to your financial assets are caused by capital erosion.
The 3 Main Types of Capital Erosion That Any Business Should Be Careful Of:
1. Profit Erosion
In the case of profit erosion, your money flows away from profitable segments of your business.
In other words, instead of funding profitable projects within the business, your profits are redirected to some new areas that may not be profitable.
We often call this an investment for the long-term well-being of the company.
However, the short-run consequences can include hampering the cash flow, which can make the daily routine functioning difficult to carry on.
In addition, if the new projects that you invest in are unable to generate enough profits in the future, your financial health could worsen further. This can often be reflected in the profit margin records. If the new products result in additional costs like labour, machines, etc. with no significant rise in sales to cover them, profit erosion can indeed become a serious problem.
Therefore, every time you decide to invest somewhere new, make sure that you look for a long-term benefit instead of a short-term gain.
2. Asset Erosion
Ever heard of the term "depreciation"?
When an asset loses its value, the process is commonly known as depreciation. This loss happens unexpectedly and cannot be avoided. A simple way your property, machines, or any other asset can lose value is simply through regular use of them.
The more you use them, the fewer returns they will give you after a certain period of time.
Additionally, in cases of technical assets, a new technological advancement can also result in the loss of value of your current value.
If you are involved in an option contract, you must definitely take this type of erosion into account. Since they come with an expiry date, options on assets like stocks can actually erode (lose value) over time! As the expiration date approaches, your chances to earn a profit from the contract will start to fall. This process is often known as time decay.
3. Sales Erosion
As the title suggests, sales erosion would mean a steady decline in the sales of your business as the time passes by.
But why would this happen?
There can be several factors responsible for this. For instance, the entry of any new business in the market, price cut-down to increase sales by some other business, or simply if there is any technological advancement that hampers the sales of your business products.
What To Do to Prevent Harm to Your Personal Savings and Investments?
The solution lies in eliminating the risk of letting your portfolio be exposed to a single asset class. Reallocate your investments and decompose them among equities, gold ETFs, and debt funds.
Also, once you’ve set up any investment plan, make sure to keep switching and updating it as per market conditions.
For instance, a surge in the stock market should encourage you to invest in stocks or equities.
Similarly, when the market feels volatile, turn to more secured investment options, with gold always being the safest. Additionally, try our different mutual funds.
Some assured and safe investments like securities, NPS, PPF, etc. must be maintained to keep a strong financial backup. Also, inflation is something you can never avoid while examining the erosion of capital.
Don’t stock your money, invest it smartly. Plus, to reduce the effects of inflation, make sure you purchase property that has the potential to increase its value over time. Make sure to maintain an emergency fund and buy insurance policies!
Capital erosion is a prevalent yet ignored phenomenon. However, if you wish to have a strong financial backup, you must keep a track of the values of your asset.
If any of your assets start losing their value with no potential gain in the future, you must get rid of it. Never let your asset turn into a liability! Switch whenever you feel the need and make sure not to stick to a single financial instrument.
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