The Power of Compounding!!

 “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn't, pays it.” -  Albert Einstein

In my last post, I explained how two persons, one starting saving just 1000 per month at the age of 21 and other starts saving at the age of 22, would have a difference of more than 3.8 Lakh in their net worth at the time of retirement. That 12000 not saved earlier would become 3.8 Lakh at the time of retirement. This is the power of compounding. 

Compounding means, that the interest you receive on your investment/ saving today keeps on adding to your savings and investment for the future years, and hence the money keeps on growing exponentially. A simple chart on how FD investment of 1000 would grow over the next years -:

As you can see, the amount 1000 grows to about 3400 in the first 15 years, and then more than 14 times at the end of 30 years. The amount grows exponentially during the last years.

This is just assuming that a person has invested only 1000 during the start and then nothing after that. 

To give a real understanding on this, let’s assume there are four people who start investing as follows. Assume that all of them invest in the same bank with a rate of interest of 9% and all of them are 25 years of age, retiring at the age of 60.

1) Akash ( A disciplined investor) – As soon as he gets a job at the age of 25, he starts saving Rs. 3000 every month and saves upto his retirement (For next 35 years).

2) Amar – He starts working, but thinks it’s too early to save, so he does not saves anything. At the age of 35, he realizes that he should start now, and starts saving double than Akash ie Rs 6000 for the next 25 years.

3) Ashish (A late investor) – He’s a person who does not invest anything, until he realizes it too late. So, in order to make up for it, he starts investing 30000 per month when he’s 50 years of age for the next 10 years.

4) Ajay  (A smart and disciplined investor) – He’s the smartest of all. He thinks to save as much he can for next 15 years, and then stop investing since he’s in a phase of his life when he’s married and the kids going to school, and he also wants to spend money on himself. So, he saves Rs. 6000 per month only for the next 15 years (up to age of 40) and then stop investing anything, but does not touches the amount he has already invested till his retirement.


Who do you think is the most intelligent person?
Let us see what the net worth of each person will be when they retire at the age of 60.

Akash – Saves 3000 per month for next 35 years – 87,43,353 (87 Lakh)
Amar – Saves 6000 per month for next 25 years – 67,02,286 (67 Lakh)
Ashish – Saves 30000 per month for only next 10 years – 58,26,867 (58.2 Lakh)
Ajay – Saves 6000 per month for 15 years, which grows to 2273709 when he’s 40. Now he does not touches this and saves it in a fixed deposit for next 20 years. And he’ll have a net worth of – 1,34,83,425 (1.34 Crore) at the time of retirement.

So, you see that investing early in life rather than later makes a whopping difference at the end. This is because the interest that you get is much higher if your principle amount is huge, and the time to grow the money is also higher. The amount grows exponentially if given a chance to grow with a good time frame. 

During these calculations, I assumed the safest option of bank recurring and fixed deposits giving a interest rate of 9%. But in the real world, with investing into stocks/ mutual funds and with reasonable time frame, one could easily get a return of 12-15%.

P.S. – For all the calculations, I used excel formulas, but you can check these at the following links.

http://allbankingsolutions.com/fdcal.htm
http://www.allbankingsolutions.com/Recurring-Deposit-Calculator-India.shtml

Managing your money - 8 basic tips for starters.

For my last blog, my sister commented that she did not understand much out of it, so I thought to write another blog on “Money Management” for the next generation, who’ll be entering into the professional life pretty soon.

Couple of things here – This is a vast topic, and depends on individual interests, so there’s no way everything can be put here. I’ll try to keep this simplistic without using any jargon’s and share my learning’s and mistakes from my past.

1) Savings, the easiest way – Would you spend the money that you don’t have? You cannot. Hence, the easiest way I think to save money is to transfer it to a “dummy” account. Destroy the ATM cards for that account, do not add any payee’s for transfers. This account is for your single future need – your retirement. Transfer money to this account as soon as you get your salary, and do not touch this no matter what. Believe me, this is the easiest way to save your money and to avoid un-necessary expenses.

2) Share with the society – I heard a news recently, where a boy who could not pay his school fee from 9th thru his graduation, got into IIM because a gentleman paid his fee. Think of the joy both the kid and the person would have. Sponsoring education for 1 needy child would mean eating out 3 times a month instead of 4, or giving up movies once in a month, it just costs 1000 bucks!! Country would progress in a much higher rate if everyone is educated, and progress would mean increase in salaries!!

3) Start investing early – You may think it’s too early to start saving for retirement, when you have just entered your professional life. NOT TRUE. Here’s an example, if a person A start investing 1000 per month from the age of 21, and a person B starts investing 1000 per month at the age of 22 (investing 12000 lesser than A), the difference in net worth when they retire at the age of 60 would be a whopping 3.8 Lakh. (Source - http://www.allbankingsolutions.com/Recurring-Deposit-Calculator-India.shtml)
This is called the power of compounding. Having said this, it's never too late to start, so if you are not already doing this, start today.

(More on the power of compounding in my future posts).

4) Don’t put all the eggs in the same basket – If you are going for a holiday trip, will you put all the money in the same pocket? Every one puts money in different pockets, to avoid losing it all in case something happens. Same if true for your investments, put your saved money into all types of investing instruments – Gold, Recurring Bank Deposits, Mutual Funds, Insurance, PPF etc.  All these instruments have a different degree of risk, and have different returns. Point here is, never to keep all your “eggs” in the same basket, always diversify.
(More on diversification of your investments in my future posts).

5) Stock Investments – This is one of the easiest way to lose your money, and the fastest way to increase or earn money. But this comes with a “risk”. Until and unless you have a very good knowledge of the stock market, keep away from it. When people say this is a game of luck and a chance, they say it so because they don’t understand the workings of the stock market. Stay away from direct stock investments, until you’re really sure about it and have a good research done.  It’s not easy to get returns from stocks as a side business. You have to spend all your time, efforts and knowledge to gain out of this. Easier way is to go through the Mutual Funds, where your money will be managed by a professional, who’s knowledgeable, and paid to this.

6) Set a budget – Jot down your monthly expenses, and start tracking them. Then, set a monthly budget for each category and stick to that. You’ll be surprised to see the money you are spending that’s not really needed and being able to save and lead a more financially disciplined life.

7) Credit Cards – As soon as you start working, and have an income coming in your account every month, it’s very easy to get a credit card. And once you have a card, it’s very difficult to “not” use it. The interest rates for outstanding credit are around 38-42% per annum, and unless you pay the entire amount, the credit will keep increasing due to these interest and late payment charges. Credit cards are a great tool for spending, and saving money on spends, but only if you are disciplined enough and spend wisely.
(More on the “vicious circle of credit card debt” in my future posts)


8) Salary and Taxes – A lot of people I met, did not understand the components of their salary sheets and were happy with whatever gets deposited in the account. Understanding the salary slips and its component is the first thing you should do when you get an offer. Once you understand the components, it’ll be easier for you to save on taxes. There are a lot of components when coming to save tax, and person who’s earning more in the same company can pay lessor taxes. Of course there’s a limit up to which you can save, but make sure you are utilizing all the tax saving instruments and save maximum.

Investment + Insurance - Do you really need endowment policies?

Recently, I got a call from one of the insurance agents, giving me a plan which seemed out of the world. A little calculation proved how these insurance agents mis-sell their products, and how the top minds from the business schools do their best (and succeed) to sell these.

Below is the plan from the insurer (I would refrain from naming the insurer)

Plan A – Pay 60,000/- per annum for a policy with sum assured of 15 Lakh for 20 years, and get a life time pension (yes, till the time you die!!) of 60,000/- from 20^th year onwards. Consider that the person is a 30 Year old male.

This would seem too good to be true at the first sight, but devil lies in the details.

Let’s consider the (only) two possibilities-:

1. The person dies before the completion of the term, and insurer pays him the SA of 15 Lakh, and the policy is closed. 
2. The person pays all the premiums and insurer starts paying him the pension of 60000 per annum till the time he’s alive (Let’s assume the maximum age of 100 Years – So insurer pays him from 50 years age to 100 years age, i.e. for 50 years).

Excel provides a very powerful formula to calculate the returns when you are investing and getting money back at regular intervals. – IRR.

Below is the table that shows the IRR or – Rate of return for the policy.

Now, type the formula as =IRR(B2:B100). (Or, select all the values of amount paid).

The result you see will be 2.88%. That means, the overall rate of return if you are alive till 100 years of age, will only be about 3%. 

Age	Amount Paid (-ve)/ Received(+ve)
30	-60000
31	-60000
….	-60000
….	-60000
48	-60000
49	-60000
50	-60000
51	60000
52	60000
….	60000
….	60000
98	60000
99	60000
100	60000

Now, consider that the person goes via another route – that of separating insurance and investment, and create a similar plan for him.

Here’s how it looks like.

Plan B:

1. Term insurance for 50 Lakh with tenure of 30 Years. Premium for this person will be about 10000 per annum.
2. Recurring deposit for 20 years in a nationalized bank (Safest option assuming 8% interest rates) for the rest of the amount – 50000 (approx. 4200 per month).

Now, again there are only two possibilities -:

1. The person dies within the age of 30 years, he gets 50 Lakh (SA higher than LIC, and Cover period 10 years more than LIC), and has some amount in the RD option. 
2. The person completes the 20 years of recurring deposit.

If you see, the amount he gets back after 20 years of recurring is – 28,02,295. (Source - http://www.allbankingsolutions.com/Recurring-Deposit-Calculator-India.shtml)

Now, a simple calculation would show, that interest income on 28,02,295 assuming 8% interest (on PPF/ FD’s etc.) would yield about 2,24,180 per annum. 

So the person can withdraw a pension of 1,00,000 (much higher than the pension in plan A) and re-invest the remaining amount. This would mean, he gets a pension for the rest of his life, and his investment keeps on growing.

The above example assumed the safest options of investments (RD, FD, PPF’s etc.). If the person has a long term horizon (e.g. 10+ years), then a mixture of investment into Gold, Mutual Funds and Stocks etc. may fetch a return of more than 15%.

A huge number of LIC plans which are sold, fall in similar category, i.e. – A mixture of investment and insurance, which rather give a very low return. A classic example is the money back policy-:

http://www.licindia.in/periodic_moneyback_003_benefits.htm

If you try to calculate the IRR for the above policy, it'll be about 7% (best case) and 3% (worst case) as per the numbers provided on the page, which again, I think is not a good option.

In my opinion, any sort of a which mixes investment and insurance, can be broken down and a much better plan can be created using the above example.

A question may arise, as to why people would go to LIC if it were so bad? I can think of two reasons

1. A lot of people do not go into details, and do all sorts of calculations. They tend to go with what the agents sell them. 
2. Traditionally, LIC was the only major player in this field, but now, with a lot of private players coming to market, I think the trend may change.

So, do you have a LIC plan? Or are you planning to buy one? Or would you rather separate your insurance and investments? Do post your comments/ questions.