(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)


Rate

5 years

10 years

20 years

30 years

6%

1,338

1,791

3,207

5,743

8%

1,469

2,159

4,661

10,063

10%

1,611

2,594

6,727

17,449

12%

1,762

3,106

9,646

29,960

16%

2,100

4,411

19,461

85,850

20%

2,488

6,192

38,338

237,376

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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