(Author is an alumni of NITK,Surathkal and is presently pursuing Management studies at IIM, Bangalore. He was previously employed with Microsoft and Intel, and he also owns a ALOHA-Abacus franchise at Kulshekar, Mangalore. All views expressed here are his personal. He can be reached at )
Understanding Personal Finance: Part-1
Many children and even some of the adults dislike mathematics and/or working with numbers. Unfortunately, it is a very crucial subject we, every one of us, apply the most in our day to day lives. So is the case with finance. Most of us think it is a complicated word or at least we think we do not understand the word. While we assume we do not understand, our options and choices are limited. Whether it is an investment or leveraging loans, we should evaluate and make the right choices since these are the important things, which can make a big difference in the long term. We can be financially independent and we can retire early if we plan and make the right choices.
We all have a general idea of what finance is. There are various definitions to the word ?Finance’. Finance is the science of managing money. Finance is the most encompassing of all business enterprises. However, personal finance can be managed by using simple accounting programs. A simple spreadsheet such as Microsoft Excel can be used for individual record keeping of investment/income and expenses.
So let’s try to understand a bit of personal finance.
Sanvy, a bright engineering graduate, who got recruited by one of the prestigious multinational companies through campus selection, was extremely happy to see her first salary in hand. Her dad who was a chartered accountant by profession had educated her on some of the financial knowledge he had acquired. Applying this knowledge, from the very first month itself, she started her investments with a monthly investment of Rs1000/- and she has plans to continue the same for a total period of 10 years. Great!
You must be wondering why this investment at such an early part of her career. After all, she is just out of the College and barely 22 years old. Isn’t it a too early to start thinking about investments? Well, she thinks otherwise. She wants to leverage the benefits of investing early and create a long term wealth. Altogether, a different but wise contemplation.
Let’s first look at what is the wealth creation trick that Sanvy is using here. She is investing Rs1000/- per month, every month, for 10 years. After 10 years she wants her capital to grow without any additional investment. So, her total investment for 10 years would be Rs 1,20,000/-. Let us consider that her investment is growing at constant rate of 12% year after year, what would be the value of her investment when she retires at the age of 58? Its Rs 43,80,575/-. A whopping 36 times her original investment! How can that be possible? Hard to accept as true but that’s how the money keeps growing. Albert Einstein called this phenomenon of compounded growth as eighth wonder of the world.
Let us try to understand this concept in detail. The prerequisite here is to understand the Inflation Rate. Inflation, to put in simple words, is the additional amount of money a consumer pays this year compared to last year for the same product or service. India’s inflation rate is close to 5% at the time of writing this article and is usually contained within 6% range. This also means that on an average the prices in India rise 5% year after year. So when it comes to investment, one has to invest in an instrument where it beats the inflation. In other words, in India, any investment earning less than 5% returns is a loss to investor. So don’t just save your salary, invest it.
Now, let us revisit the power of compounding. When our investment returns are higher than the inflation rate, our money grows. As we all know, if we reinvest this additional amount, it will also start growing along with the original principal amount. This compounding has an exponential effect if invested for long term. Even a small increase in interest rates can make a huge difference – it is a simple math!
Consider the Postal savings investment, with 8% interest year on year, a principle amount of Rs1lac would become Rs16 lacs in 36 years. Whereas, the same investment at 12% interest rate year on year would become Rs. 59lacs in 36 years. A 4% difference in interest rate creates a huge difference of Rs 43lacs in this case. At 15% year on year, it would become Rs1.5Crores. Is there a catch here? Well, if you take a closer look, getting constant interest rate/ returns from single instrument is difficult. But the point to note here is, if the possible returns are higher, then it is more likely to grow in many folds over the years. This is exactly how Sanvy is planning to create wealth. She has taken up Systematic Investment Plan with one of the Mutual Funds companies where she expects the returns to be anywhere in the range of 8% to 20% year on year. Well, she looks very optimistic and why not, Indian economy is poised for huge growth in the coming years. She might end up getting 15% on an average and value of her investment might cross well beyond one crore Rupees.
Another important concept we need to understand while investing is the present value of future returns. What is the present value of one crore rupees after 36years? Let us understand it in detail in Part-2.
Author: Pramod DSouza- Bangalore