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Why should we INVEST? Are there RISK-FREE ways of growing my Money?

WHY INVEST | GET YOUR MONEY TO MAKE MORE MONEY
Posted on November 22, 2010 by Donald
Why Invest? Get your money to make more money and build long-term wealth. In the process you beat inflation, achieve financial goals, and provide for a comfortable retirement.

Why Invest at all?
Why invest? This came to me sometime in late 2004/early 2005 as I strongly felt the need for making my money work better for me. We were blessed with twin daughters, and full of hopes and dreams.

I was transforming to become more financially responsible and aware. No one needed to educate me on why invest, as I suddenly realised that to achieve these dreams, I needed to shed a bit of my happy-go-lucky attitude and set longer term financial goals. And to achieve these financial goals, I needed to invest!

Investing to me, is focused primarily on making my own money (work harder, and) make more money for me. It is clearly about long term financial goals. As I started reading up and thinking more about building long-term capital, certain simple why invest basics became very very clear to me.

Time Value of Money
Like most things in life, the early bird catches the worm! I understood I was already late into the game. Realised I could never play catch up – even if I doubled the stakes – compared to having started just 10 years earlier.

Consider the graphic below. Suppose you start early at age 20, invest Rs.20,000 yearly for 10 years in a safe government-backed instrument like PPF (Public Provident Fund) and forget about it-just let it lie in the bank till retirement. And somone who wakes up somewhat later in life, at age 31, and starts investing double that amount Rs.40,000 every year for 30 years, till he reaches the age of 60.

At age 60 You, the Early Starter would have invested just Rs. 200,000 and seen your investment grow to ~Rs. 3.4 million, and seen a return of 16x. Someone like me who woke up later, will have invested a not inconsiderable Rs. 1.2 miliion, but seen only a 3x return!

Wished I could start the game all over again? You bet, I did! Understood perfectly this aspect of time value of money or what is also called the power of compounding. The longer your money remains invested, the better it works for You! Why Invest, became a no-brainer.

By now my mind had started ticking! Hey wait, what if I could make my money work just a bit faster?

Compounding at different rates
It appeared to me now hey, there are other financial instruments too. If I can make my own money work just a bit harder and faster, perhaps I could play catch up? Lets see how the figures stack up.

Now this was getting interesting. Compounding at just 2 percent more per year every year for next 20 years made for a sizeable 44 percent difference in overall returns. And over 40 years the 2 percent difference more than doubled the returns! Why Invest, indeed!

Now I had learnt my math in school, and knew this is due to the power of compounding! But had I ever worked figures through like this? The miracle of the power of compounding ensures that our investment makes money and the return on that investment makes some more money – keep it that way for a number of years and our investment quickly starts exploding. The more the time our money remains invested and/or earns a higher return, the higher the trajectory of our returns graph.

The Thumb Rule of 72
How long will it take to double my money? From a why invest novice, someone was getting greedier here!

The Thumb rule of 72 comes in handy here. Just divide 72 by the interest rate and you have the number of years it takes to double your money, roughly. So if we are getting a 8% interest rate, it will take 9 years. And at a 15% rate, your money doubles in roughly 5 years. Use a calculator, or an excel worksheet to Test this! Its an amazing thumb rule to keep in your head.

So the next time an agent comes to you, preaches why invest, and talks about doubling your money in 10 years, you know that it means compunding at a rate of 7.2% only. And that you have better options. On the other hand if he is promising the moon, you know how to bring him down to earth with some quick incisive queries.

Other Why Invest considerations
There are a few other considerations too.

Post-tax returns

Many instruments are subject to tax, while some are not. I might be getting a nice 9% annual return on say my fixed deposit, but what is my effective post-tax return? Probably no more than 6.5% compounded annually. You know that’s a paltry return vis-a-vis some other risk-free return instruments, right?

Real Returns – Inflation

And there is the bigger factor of inflation. Inflation, measured as an annual percentage increase, is a sustained increase in the general level of prices for goods and services. As inflation rises, every rupee you own buys a smaller percentage of a good or service. None of us could have missed (even if someone else buys our groceries) the high inflation figures cited by the press in 2008 – so what happens to my real rate of return? Post-tax return minus inflation? While 2008 saw inflation figures topping 11%, the long term average rate of inflation is ~5% in India.

With a 6.5% post-tax return and a 5% inflation figure to absorb, my real rate of return was zilch. I didn’t need more pointers on why invest. Do you?

Different Investment Options

Now that you are better informed on the why invest proposition and the horrifying real-rate of return, you sure want to understand more about the common investment options available to us in India, the pros and cons, taxability, risk and typical return levels associated with each instrument.

Certificates of Deposits

These are short-to-medium-term interest bearing, debt instruments offered by banks. And are low-risk, low-return instruments. There is usually an early withdrawal penalty. Fixed deposits, recurring deposits etc. are some of these.

Average rate of return is usually between 5-9%, depending on duration/instrument. Returns are taxable.

Bonds

These are fixed income (debt) instruments issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with fixed rate of interest on a specified maturity date.

The average rate of return on bonds and securities in India has been around 10-12% p.a. Returns are taxable.

Public Provident Fund (PPF)

One of the best instruments available. Must have in your investment portfolio. Scheme can be opened with SBI, leading Pvt. Banks, and Post offices. This is a long term investment vehicle with a term 15 years. Maximum deposit in a year Rs. 150,000 with the current rate of return fixed at 8%. It’s a good idea to first maximise this Rs. 150,000 limit every year before putting surplus money into other investments.

Why? For one, because of the longer term you can unleash the miracle power of compunding to good effect here. Besides its a tax saving instrument, completely safe, risk-free government guaranteed instrument. Returns too are currently, tax free.

Post Office MIS (POMIS)

This is another popular scheme among those who need some regular monthly income, say e.g. Senior Citizens. You may not need the regular monthly income, but hey you could put that regular stream of cash to other investment avenues, such as a reputed mutual fund SIP, compounding at a higher rate, ofcourse!

Again a risk-free instrument you can invest with at Post Offices. Maturity period is of 6 years, with current rate of interest fixed at 8% compounding. Automatic credit facility of monthly interest to a linked savings account at the post office. There is a bonus 5% payable on maturity, so effective compounding return goes over 10%. Returns are taxable.

Stocks

Investment in shares of companies, is investing in Stocks. Stocks can be bought/sold from the exchanges (secondary market) or via IPOs – Initial Public Offerings (primary market).

However unlike Bonds or Certificate of Deposits, investing in stocks isn’t risk free. The market returns over the long term is dependent on the company’s business performance – after all buying a share is a part ownership in the company! If you are going to trust your investment with a company for the longer term, you need to be reasonably sure the company will stay in business for next 10-15 years, and profitably! Investing in shares is not for everyone, requires hard work, a lot of discipline and patience to make a success of it. Else all the analysts would be sitting at home and rolling in the moolah, right!

Having said that, history shows us that investment in quality stocks have proven to be the ideal long term investment. On an average an investment in stocks in India has provided returns of 15-25% p.a. over the medium to long term. Dividend Income and Long Term Capital gains (>1 year) in India are currently, tax free.

Mutual Funds

These are open and close ended funds operated by an investment company which raises money from the public and invests in a group of assets, based on a published set of objectives.

Investing in Mutual Funds provide benefits of diversification (investments spread over a larger number of stocks and thus lesser risk)and professional money management -they have the team of researchers and analysts to pick the best stocks for you.

The rate of return again is market-performance related; generally substantially more than what is earned in fixed deposits. Each mutual fund has a rate of return dependent on how well its stock-picks have performed in the market.

Good Mutual funds in India have given a return of 15–20% p.a. over the long term. Dividend Income and Long Term Capital gains (>1 year) in India are currently, tax free.

Others

There are also other savings and investment vehicles such as gold, real estate, commodities, art and crafts, antiques, foreign currency etc., which too can be considered.

Wealth Creation studies in India

Finally as I dug in more on the why invest case, I was lucky to come across the extensive Wealth Creation studies conducted and documented by Motilal Oswal on the most consistent wealth creators in India.

That was an eye opener for me as I learnt how some of the best and trusted names in India have delivered more than 30% compounded returns annually (with all dividends re-invested), over the last 15 years and more. Names like HDFC, Infosys, ITC figure here – but more on that, later.

Using the thumb rule, I knew a 30% compounding rate means doubling the money in 2.4 years. Amazing. I was even more astounded when I used the excel sheet to work out that with 30% compounding, an investment of Rs. 20,000 in ITC 15 years back and left untouched, would have grown to Rs. 1.02 million, or grown over 51 times! Why Invest I asked no more, I became a convert.

As I digested this better, I resolved to gift my wife 100 ITC shares, for her next birthday. To her credit, she didn’t quiz me on why invest! But you are, I know, I know …there are no gurantees, but what the heck, that smokers will keep smoking is a good enough bet, or what?

Well that’s the run-down on some important basic why invest realisations that convinced me why I should invest and made me a committed long-term investor. Hope, it is equally convincing for you too.

Related content
How to Invest |Understand Return and Risk |Risk Return analysis
How to Invest |Return requirements |Risk tolerance |Your Investment profile
Where to Invest |Asset Allocation |Portfolio diversification

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My financial literacy began with these - the post is a bit dated - but I guess the essentials remain the same.

We could perhaps use this as the Influencing Topic Opener on Personal Finance - that could encourage folks just starting out to ask 2nd level personal finance questions.

Some of the best Personal Finance websites (in India) I found in 2005, when I started out

ValueResearchOnlne - No exaggeration, when I say I learnt all my basics at this site

PersonalFn - This place had some very useful guidebooks published (Retirement Planning, SIP, MF, etc.)

Both Resource Sites should have only gotten better in the last 10 years

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good one. i am surprised to see a basic personal finance related post from someone like Donald and that too in valuepikr.
do we have a “how much is enough” or “what is the corpus required for fin freedom”? kind of thread here?. that would be a very interesting topic to discuss.

PPF is definitely the best safe investment. One more thing I would like to share is that though the said scheme is for 15 years, it can be extended for another 15 years n number of times.

PPF can be extended in blocks of 5 years, after the initial 15 years period. The extended 5 year blocks can be either “with contribution” or “without contribution”. If you choose “without contribution”, you can withdraw partial amount from the PPF balance (only one withdrawal per year) and the rest amount continues to earn interest.

Correct. Sorry for wrongly typing 15 years instead of 5 years.

There is another good scheme launched recently w.e.f. 1.04.2015 viz., Sukanya Samriddhi by the Govt. of India. This can be opened in the name of girl child upto 10 years only. However, there is a one year grace period so that the girl who is born on or after 02.12.2003, the account can be opened upto 01.12.2015. Donald, this is good for your daughters :smile:

The rate of interest for the current FY 2015-16 is 9.2% (tax free) which is better than PPF being 8.7%.
Minimum and max amount of contribution is Rs. 1000 and Rs. 1.5 lac p.a respectively.
Rs. 1.5 lac invested annually for 14 years becomes around Rs. 80 lac after 21 years and that too Tax free (assuming the same rate of interest in future also).

The best part is that one can invest the maximum limit of Rs. 1.5 lacs in PPF over and above this investment.

The highlights of the scheme can be seen from the following links:
http://www.onemint.com/2015/03/09/sukanya-samriddhi-yojana-calculating-maturity-value-after-21-years/
http://www.onemint.com/2015/04/03/sukanya-samriddhi-yojana-calculating-maturity-values-9-2-interest-rate-applicable-for-fy-2015-16/

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Anuranjan

Didn’t know there is a 1 year grace for the Girl Child scheme. Shall enquire at SBI tomorrow. Thanks

Why You Should Think Beyond Fixed Deposits

This is a story of two friends – Katrina and Deepika. Both of them got married in the year 1980.

Katrina comes from a conservative family whose members mostly put the money their hard-earned money in a bank fixed deposit. The reason was simple – fixed deposits are “safe”. There is no fluctuation and you consistently earn interest every year without fail. Katrina was always told that investing elsewhere was a gamble and it is best to be in the safety of fixed deposits. At the time of her wedding, she received Rs. 100,000 from her parents to be used for the wedding of her child. She promptly invested this sum in a fixed deposit and renewed it every year. She was quite happy and at peace that she would be able to take care of one of her major responsibilities in life.

Deepika is a lot like Katrina except that she had somehow heard and ended up reading about Warren Buffett, a man who had made millions investing in businesses listed on the stock exchanges in the USA. Like Katrina, Deepika also received a sum of Rs. 100,000 from her parents to be used for her child’s wedding. Since the goal for which she was investing was in the distant future, Deepika invested this money in the Indian equity markets, i.e. an index fund replicating the Sensex.

Let’s take a look at how they fared in the ensuing years:

What is most staggering about the above chart is that starting with the same sum of Rs. 100,000 both ended up having vastly different results. To bring home this point, let’s compare how much gold would they have been able to buy in March 2015 as compared to 1980 when they got married.

In 1980, both Katrina and Deepika would have been able to buy about 750 grams of gold with the Rs.100,000 that their parents gave them (gold price at the time was around Rs. 1,330 per 10 grams). However, by 2015 gold prices had increased to Rs. 26,500 per 10 grams. Katrina’s investment of 100,000 increased to Rs. 21.70 lacs with which she would have been able to buy 820 grams of gold in 2015 (not much better than what she would have been able to buy in 1980). In other words, even though Katrina had more money in 2015, she barely had an increase in purchasing power. Delaying her purchase of gold did not give her any real advantage. She might as well have bought 750 grams of gold in 1980 and sat on it. It would not have made much difference.

On the other hand, Deepika’s investment had grown to around Rs. 2.2 crores by the end of financial year 2014-15. With that kind of money she would have been able to buy an astounding 8.2 kilograms of gold. Yes, 8.2 kilograms of gold - 10 times more than Katrina!

Agreed, Katrina had a smoother ride than Deepika – Deepika experienced quite a few fluctuations in her investment journey. But, even with those fluctuations, she fared much better than Katrina.

Wait; there is more bad news for Katrina!

The returns that have been considered are only pre-tax returns on fixed deposits. In case taxes are taken into account, the returns on the FD would have been worse. Just to give you a perspective, if an average tax rate of 30% is assumed, the value of Katrina’s investment at the end of 2014-15 would have been a paltry Rs. 9 lacs. She would have been able to buy only 335 grams of gold in March 2015 compared to 750 grams in 1980. Thus, by “investing” her money in a fixed deposit, she suffered an erosion of more than 50% in her wealth.

Further, any dividends that Deepika would have received from her investment have also not been considered for sake of simplicity. Had the same been included, her investment results would improve, in turn widening the gap between Deepika’s and Katrina’s investment returns.

What can we learn from this?

Investing in Bank fixed deposits may not be volatile, but you would be well advised not to equate “volatility” with “risk”. They are two very different things. And as it turned out, the investment with negligible volatility ultimately ended up being the one with more risk.

As I leave you, just take a moment to ponder over the following questions:

  1. Don’t you think it is wise to think in terms of purchasing power instead of paper money?

  2. What should be a bigger cause for worry – loss of purchasing power or temporary fluctuations in an investment?

  3. In the end, do you think Katrina would be filled with regret about her decision to invest in an FD? Would knowing Deepika’s investment result change anything?

John Maynard Keynes once said, “The difficulty lies not in the new ideas but in escaping from the old ones.”

I think it’s time we paid heed to his advice.


Data Sources:

  1. Historical fixed deposit rates: Reserve Bank of India – Handbook of Statistics on Indian Economy 2013-14. Note that fixed deposit rates for the years 2011-12 to 2014-15 have been assumed.

  2. Historical gold prices: Commodity Research – Economic Times

  3. Historical Sensex levels/ returns: Bombay Stock Exchange website

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