Sunday, June 7, 2015

Compounding of Money, Rule of 72 and some basics that time forgot

(This piece appears in Deccan Chronicle)

Investing should not get complicated. You either love it or hate it.  Some of us like to spend time understanding stocks. Most of us do not want to know about its existence, but the noise bothers. We all think that either the stock market is one big scam designed to cheat us out of our savings or it is a casino where money doubles faster than we can fold a currency note.

We all need to ‘reformat’ our thinking when it comes to investing. Money is an important part of our existence ( hopefully not the sole purpose ). It is an aid to living and not an end in itself.

Let us understand that big wealth has been created mostly by owning businessess that do well. Very few people have created big wealth from stock markets alone. The fact that we find it dificult to recall more than a handful of names that made it big from investing, tells us all.

Stocks are perhaps the fastest way to growing wealth, IF risk is managed well and you have the right attitude. A bank account may give us, say nine percent annualised return. Stocks may give us around fourteen percent (a random number- assuming six percent inflation and eight percent GDP growth).  You may think that all I am losing is a five percent return for something unknown.

Unfortunately, due to our schooling system, innumeracy is rather high,.  Let me put across a table to you that shows the impact of Compound Interest:

(Value of Rs.1000  at different rates / diff periods)
 5 years
 10 years
 20 years
 30 years

The first row is the rate of return at which a sum of ONE THOUSAND is ‘compounded’.  The next rows are the maturity amounts at the end of different time periods.  Thus, 1338 is the sum at the end of 5 years, at 6% Compounded. It is 5.743 at the end of 30 years,  Similarly, if we can get 12%, the amounts at the end of 5 years is Rs.1,762 or Rs.29,960 at the end of 30 years.  The difference between 6 and 12 is just 6 or it is double the rate. However, Compounding it, at the end of thirty years, 12% is 29,960 and 6% is 5,743.  Over five times!

It shows us the importance of fighting for that one or two percent return, on a longer time period.

This table also gives us another very important lesson. For example, if I were to start investing and get returns from, say age 40, at the end of 20 years, when I am 60, 1000/- would have become 6,727. If I had started just five years earlier, at age 60, I would have had  17,749!  Nearly three times. This is why everyone tells us to ‘start young’. Probably it is repeated so often, we think it is a cliched phrase and ignore it.  

You will become easy with it, once you understand something as simple as a ‘rule of 72”.  For example, you want to know how long it will take for your money to double, at , say 8%.  Simply divide 72 by 8 and the answer, 9, is the number of years it will take. Similarly, if someone promises to double your money in six years, just divide  72 by 6. The resulting number, 12, is the annual rate of interest on your money.  This is a very close approximation and not mathematically precise.  So do not let anyone fool you. Now you can easily work out the consequences of starting late in life, when it comes to savings.

Once you understand your compounding tables, you can decide when you want to save, how much etc. Of course, the table will not tell you about the risks  In fact, use the power of compounding to retire early by saving more in the earliest periods of your earning life. .

The purpose of introducing the above table was to demonstrate what it means to invest in stocks rather than keep money in the bank. I think it is feasible to look at a return of 12 to 14 percent compounded return from stocks, over the very long term. This is a conservative number. And you do not even have to choose which stock or which mutual fund. Buying the index, through a proxy, like the Nifty or Sensex ETF should be good. This will save you from the risk of having to choose a mutual fund scheme that may underperform the index.

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