Investment Planning

February 2010

Invest Early, Invest Wise, Utilize Magic of Compounding

Invest Early, Invest Wise, Utilize Magic of Compounding, Time value of money.

If you have built castles in air, your work need not be lost; that is where they should be. Now put the foundations under them. —- Henry David Thoureau, Walden.

In the previous post , I had mentioned about the importance of time value of money. Let us see here the impact of the same over a period of time on investments – And why investing early and then making it work for long periods of time makes such a BIG difference.

In this example , Early Investor starts putting aside Rs 10,000 a year beginning age of 22 yrs until the age of 30 and then decides to stop making contributions. Over this time, he puts aside a total of only Rs 90,000.

On the other hand, Late Investor doesn’t start making contributions until he is 31 and puts aside Rs 10,000 a year until he reaches age 65. Over that time, his contributions total Rs 3,50,000.

In both cases, assume that their account grows 10% a year. Despite the fact that Late Investor contributes  almost 4 times , at age 65 his account is hardly 2/3rd as compared to the Early Investor!!!!

This clearly illustrates the benefit of starting to invest early.

The power of time and impact on the the value of money, the benefit of investing with patience and discipline and the magic of compounding is truly amazing.

Even, if it may be late for some of you to maximize your lifetime investment potential, it may not be the case for your children.So, go ahead, start thinking , plan , and invest for long terms with conviction.

You will find the related post on Time Value of Money as interesting as it is one of the most important concepts in finance.

What is Time Value of Money

What is Time Value of Money

“A bird in the hand is worth two in the bush” – Miguel de Cervantes

The time value of money is one of the most important concepts in finance. Money that is in possession today is more valuable than future payments because today’s money can be invested to earn positive returns in future.The understanding of Time Value of Money leads to better decision making in some of the major financial decisions like — calculating sum assured requirements for your life insurance needs, computing monies which will be required for child education/wedding in future, corpus needed to fund retirement, comparing alternative investment decisions, comparing house lease v/s buy decisions, horrendous impact of carrying credit card debts etc.

What is time Value?What is Time Value of Money, Present Value , Future Value, Compound Interest, Time and their Relationship,

Money has time value. The value of Rs. 1 today is more worthy than the value of Rs. 1 tomorrow. This economic principle recognizes that the passage of time affects the value of money. This relationship between time and money is called the ‘Time Value of Money’.

If someone owes you Rs 10,000/- , it is advantageous to get the money today If you get this money today:
–> You could earn interest and invest it and you will receive this quantity plus some other amount in the future.
–> You can use it to pay your debts and therefore, lower the interest amount paid on your debt.
–> Or you can spend it and enjoy it as you wish.

Understanding Present Value , Future Value, Compound Interest, Time and their Relationship:

A sum of money today is called a present value (PV). A sum of money at a future time is termed a future value (FV).

The time period in between the present and future value can be no of years, no of months, no of quarters or any unit of period. (n).

The interest rate or growth rate in which the present value can be employed . This is the interest rate per period.(i) The effects of value versus time is best usually described by compound interest. Change in Value over time is impacted by factors like inflation, tax rates , discounting rates etc.

Future Value is calculated as follows : Future Value (FV) = Present Value (PV) * (1 + i) ^ n

Alternatively, given a future value then,

Present Value can be calculated as follows : Present Value (PV) = Future Value (FV) / (1 + i) ^ n

Compounding

Compounding is the mathematical procedure for determining “future value” and is virtually the reverse of discounting

Discounting

Discounting is the mathematical procedure for determining “present value”.

Some Examples :
1. If you invest Rs 1,000 today at an interest rate of 10 percent, how much will it grow to be after 5 years?
FV = 1000 * (1 + .1) ^ 5 = Rs 1,610.51

2. If you were given an option to get Rs 1,00,000 , six years hence OR option of receiving Rs 55,000 now. What will you choose.
In this case, you bring down the future value to the present value and then make a decision (or judgement). Let us assume a discounting rate of 12%.

So, PV = 1,00,000 / (1 + .12) ^ 6 = Rs 50,663.11.

Option A Present Value comes to Rs 50,663.11 and Option B is Rs 55,000. And the choice becomes obvious. In this way different rates can be used to make alternative quality decisions and arrive at decisions quantitatively.

3.If you invest Rs 11,000 in a mutual fund today, and it grows to be Rs 50,000 after 8 years, what compounded, annualized rate of return did you earn?

Using the above formula again : FV = PV * (1 + n) ^ i
50000 = 11000 * (1 + n) ^ 8 ; So, n = 20.84 % (Wow!! — This is a good investment)

4. Rule of 72 (Quick!!! — )

How long does it take to double Rs 5,000 at a compound rate of 12% per year (approx.)?

Approx years to double = 72/ i% (Cool!!)

In the above case it will be = 72/ 12% = 6 years. (This is rough, Actually it will be 6.12 years)

Thus, Your ability to measure time value of money can be THE vital difference between your making a good or bad investment decision.


Purpose of Investments

Purpose of Investments, Wealth Management, Wealth Generation, Accumulation, Distribution, Estate Planning, Tax Planning, Power of compounding.

The world of finance can be intimidating, But as Raplh Waldo Emerson says “Fear always springs from ignorance”. The stock market and so called greater financial world is not complicated once you become aware of the basics of investing and dispel fear of ignorance.

First let us see What is not a Investment? Now, This is fun….

First of all, Investing isn’t a get-rich-quick scheme. (There are other risky, very risky avenues of speculation to get-rich-quick which very often turn to get-poor-quick for people with no discipline and patience. Remember – High Risk , High Return, Less Risk, Less Return) . Investing is not speculation. Investing is not buying stocks on a “Hot Tip”. Always remember a Hot Tip leads to a bottomless Pit.:-). Investing is not following the herd which often leaves the investors high and dry. Investing is not listening to channels to analysts and always clicking on your portfolio to see it (along with your heartbeat) fluctuate on a daily basis. Investment should not be done emotionally (Oh, my uncle’s wife’s son’s friend’s sister wants to sell me a insurance cum investment policy, How can I say No. Well — Learn to say No. There are many things in life where you have to say No. ).  Investment is also not just about returns.

So that brings us to What is a Investment : Well, What does wikipedia have to say : “Investment is the commitment of money or capital to purchase financial instruments or other assets in order to gain profitable returns in form of interest, income, or appreciation of the value of the instrument”

Investing is putting your money to work for you in order to generate wealth. Generally Money is earned by income generated for some work done for which we trade our precious time. Problem is: for more money, you have to work more hours and give more time. And time is a limited resource. One way is to make your money work for you and start earning. Quite simply, making your money work for you maximizes your earning potential.

goal_purpose

Again, Investments have to be planned and done with a purpose, a meaning, and should be done to realize goals of life. Investments are not a one-size-fits-all manner and are individual specific, situation specific. Goals like, Retirement , Child Education, Child Marriage, House Purchase in future, Purchasing assets in future, — goals in different times/ stages of life. etc. And so Investment Planning is utmost important. Plan , Plan , Plan and then execute. Look at the big picture and do not miss the forest (long term enrichment goals) for the trees (unplanned short sightedness)

There are many different ways you can go about making an investment. Stocks, Mutual Funds, ETF’s , Money Market Liquid Funds, bank FD’s etc., or real estate , or  starting your own business. It does not matter which method you choose for investing your money. However, the objective is always to put your money to work over long periods of time (5 yrs-10yrs-15yrs+) with adequate margin of safety, and let the magic of compounding take over,  so that it beats inflation and generates wealth and fulfills the purpose and more or less  achieves the goals.

This is the most important concept in investing.