Learn the truth about compounding

This week I came across an article from Mr. Nilesh Shah, President, Axis Bank. It's worth reading & implementing. The first mantra of attaining financial independence is to start early. Like the story of an ant and a grasshopper, start saving for the rainy day as early as possible. The power of compounding makes a huge difference on early savings. Each day's delay causes loss of compounding and, hence one should start as soon as one can.

Let's make this example clearer with the help of the 1969 film ' Sachaai ', starring Shammi Kapoor and Sanjiv Kumar. Ashok and Kishore are two friends who have studied together for long and graduate at the same time. Both of them land good jobs with different cities, at a starting salary of Rs. 50,000 per month. Ashok is happy-go-lucky person and believes in enjoying his life. The monthly salary he receives is spent on cultivating a good life style. Ashok spends on branded clothes, eating out, travel and expensive gizmos. Kishore, on the other hand, is a conservative person. Having come up the hard way in life, he is a reluctant spender. He believes in not spending beyond his means. Kishore saves Rs. 15,000 every month. Obviously, he sacrifices a lot of pleasures in life. He rides a bus while Ashok prefers a personal cab. He eats at Udipi hotel while Ashok indulges in fine dining. He buys at clearance sales while Ashok goes for branded stuff.

This continues for 10 years. Ashok and Kishore meet at the college reunion. Ashok is nicely dressed and is the center of attention as he talks about the good things in life. Kishore is ignored by most as the subject of his talk is dry and boring.

However, Ashok and Kishore discuss with each other everything about lifestyle and saving. Ashok has no cash balance. Kishore talks about saving RS. 15,000 a month. Kishore talks about his simple life and Ashok talks about his colorful life style. Both of them realize they have been missing each others style in their life.

After that night, Ashok becomes a saver and saves Rs. 15,000 a month for the next 25 years. Kishore becomes carefree and does not save anything but doesn't touch his accumulated saving. After a period of 25 years, Ashok and Kishore again meet at the college reunion. By then, Ashok has saved Rs. 15,000 every month for 25 years ( albeit 10 years after Kishore started saving), resulting in a principal saving of Rs. 45,00,000. Kishore has saved Rs. 15,000 per month for just 10 years ( albeit ahead of Ashok), resulting in a principal saving of Rs. 18,00,000. Ashok has saved 2.5 times more in amount and time than Kishore. However, to the utter surprise of Ashok and Kishore, Ashok's bank balance is Rs. 2.84 crore where as Kishore's is Rs. 6.90 crore ( assuming 12 per cent monthly compounding with no tax payable). Ashok has saved 2.5 times more in terms of time as well as amount, but Kishore's bank balance is more than 2.42 times Ashok's. This surprise is known as compounding. As Albert Einstein mentioned, is does not stop and is the eight wonder of the world. The earlier you save like Kishore, the better your prospects.

Compounding is the best friend of an investor. Use it to your advantage to the hilt. Don't wait for an opportune time to save money. Start saving from whatever you have, whenever you have. Early saving is like planting seeds in fertile land. Give it some time and soon it will start growing from a small seed to a small plant to eventually a big tree. The ' Sachaai ' of financial independence starts with early saving. Hope after reading this article, your will walk instead of taking a cab and put that saving to work for compounding.

Use asset allocation to improve your returns

 

THERE is an old saying – well begun is half done. There is a strong need for financial planning to make a good beginning. Let's take Vijay Chavan, 40, sales manager with a Pharma company at Pune.

His job involves extensive travel and long hours. That leaves him with little time for family. While he is earning Rs. 10 lakh annually, financial planning does not figure highly on his agenda. When he hears a concept like work-life balance, he wonders whether he will ever be able to achieve that. Children's education, maintaining the lifestyle and a retirement nest hounds him and he throws himself at work with more dedication.Chavan does not believe in unnecessary expenditure and saves Rs. 4 lakh annually. He has built a portfolio of about Rs. 1 crore from past savings. Being risk-averse, he has put all the money in safe instruments like bank fixed deposits, PPF and PF. He is happy to see his wealth grow steadily and safely. He also feels happy when some of his other colleagues worry about the falling stock market.

Let's assume everything remains like this for Chavan over the next 20 years in terms of income, savings and investments. This unrealistic hypothesis is for the simplicity of making a point. Chavan's debt portfolio yields seven per cent return, net of tax. He will retire at 60 with wealth of about Rs. 5.51 crore. This comes form Rs. 1 crore wealth at the beginning of the 40^th year, another Rs. 80 lakh savings accruing in the next 20 years and cumulative return on accumulated wealth, as well as savings.

If we assume inflation at eight per cent annually, a lunch which costs Rs. 100 today will cost Rs. 431 after 20 years. That implies the real value of Chavan's wealth will be about Rs. 1.27 crore in today's terms. Effectively, this implies he will not be able to retire at 60 without compromising on his life style, because he ignored the impact of inflation on his wealth.On the other hand, suppose he had met a financial planner at 40 and followed a conservative asset allocation model, equally split between risky assets like equity and safe assets like bank deposits. Equity gave 15 per cent annually and fixed deposits 10 per cent. However, equity provided a tax-free return in the form of long-term gains while debt net of tax return is about seven per cent.

Chavan would then retire at 60 with Rs. 10.63 crore. Obviously, he will suffer the pain of volatility in his return in the next 20 years. But a good financial planner will make him understand the 'no gain without some pain' formula.

The pain of no surety of return, volatility, possible loss in the principal value of the portfolio are like the fever one gets in vaccination. The pain of fever after vaccination ensures one gets immunity in future. Similarly, the pain of uncertainty of return creates the gain of better return in future. If people can take their kids for vaccination, I see no reason why they can't apply the same principle for financial planning. I recommend that one embrace short-term pain for long-term gain, before it is too late.