17 October 2013

Thursday, October 17, 2013

Objective of personal finance is to have money for your needs and desires at various stages of your life. To achieve that, you should determine your financial goals and the timeline for achieving them. In this game, power of compounding is your friend; tax and inflation are your foe. Let’s understand it with a concrete example.

Say, at present you are 28 years old, and by the time you turn 58 (i.e. 30 years down the road), you want to have a retirement corpus of ₹1 Crore (₹10 million). So your financial goal is to accumulate ₹1 Crore, and timeline is 30 years. Will you believe if I tell that you can achieve this goal by investing just ₹10,000 every month in something that earns you post-tax returns of only 6% per annum? No? Neither did I when it first dawned on me. Here is the formula for compound rate of return: A = P * (1 + r) * ((1 + r)n - 1) / r

Principal amount per year, P = 12 * 10,000 = 1,20,000
Annual return rate, r = 6% = 0.06; 1 + r = 1.06
Number of years, n = 30
Accumulated amount A = 1,20,000 * 1.06 * (1.0630 - 1) / 0.06 = 1,00,56,201.

The point I am making is that even a small amount invested every month at small rate of return, over a long period of time, becomes pretty big.

Power of Compounding, at return rate of 6% per annum
Power of Compounding, at return rate of 6% per annum

You can play with P and r to get a sense of power of compounding. Say, if you had only 15 years (instead of 30) and invest ₹10,000/month, you will get only ₹29,60,703. Say, if you invest ₹10,000/month for 15 years, and then don't invest anything for next 15 years, you will accumulate ₹70,95,498.

Important take away is: time is money. Utilize power of compounding: start early, have discipline of investing regularly.

So what about inflation? If you were 58 today and retired, you think ₹1 Crore were good enough. But 30 year down the road, inflation will eat away a big chunk of purchasing power of this amount. One way to deal with it to modify your goal: earn a post-tax return of 6% above inflation (i.e., if inflation is 8% in a year, required return is 14% for that year). In future articles, I will use historical data and investment approaches to demonstrate that it is not so hard to achieve it over a long period of time.

Recap: Define your financial goal (for example, accumulate retirement corpus of ₹1 Crore, inflation adjusted, in 30 years). Use power of compounding and come up with an action plan (for example, invest ₹10,000 every month in something that earns post-tax return of 6% above inflation).

If you notice, unlike many targeting super-high multi-bagger returns from stock market, I am discussing only moderate returns (6% above inflation). It is important to explicitly state that finlosophy I follow is not for everybody, it might be useful only for passive investors. Let me specify what I mean by passive investor:

  • you are a finance layman, investing is not your bread and butter, you practice some other craft/profession to make your living
  • you don’t want your money to remain idle and inflation to erode its value, you desire your money to work to meet your financial goal
  • you can not spend a lot of time everyday monitoring your investment, you want only a little time overhead, say 3-6 hours a month.

My goal in future articles is to explain, in simple layman terms, basic finance concepts needed for personal finance planning; to demonstrate passive investment approach and its outcome with help of historical data; and to give simple tools to help executing these approaches.

Does it make sense to you? What are some of your financial goals? How do you plan to achieve them? How much time you spend monitoring your personal finance? What tools do you use? Do let me know in comments.

Update: learn the math behind the accumulated amount formula above, and useful Excel functions.

Bonus: Dilbert's take on power of compound interest :-)

What do you think?

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