We all want to grow our wealth and this brings in the importance of being Financially literated. Today, I bring to you some important concepts which if you understand well, can turn your financial life around. Today, we will go into the Power of the miracle called Compounding.
1. Multiplying your money
1% return per day for a year (365 days) will generate NOT 365% returns but a whopping “3600%” returns.
2. Power of compounding
If a Stock gives 100% return every year for 5 continuous years, then the total return is NOT 500% but instead, it is a whopping “3200%”.
Explanation: 100% increase every year means doubling every year. So, in 5 years, it will become 2^5=32 times initial Investment.
3. Compounding your money
If you invest Rs. 10L (only one time) for 50 years at a rate of return of say 14%, it doubles every 5 years, so, in 50 years there are 50/5 = 10 time period. So, Rs. 10L will become 2^10 = 1024 times ie Rs. 102 Cr.
4. Compounding vs Inflation
Reverse case/mirror image of Compounding is “Inflation”. It destroys your wealth “exponentially”.
5. Understanding Inflation and Money Devaluation
Example of Inflation or Money Devaluation:-
If you have Rs. 100 and Potato Price is Rs. 4/Kg today, you can buy 25 Kg of Potato for Rs. 100.
Next year, Potato price becomes Rs. 5/Kg. Thus the same Rs. 100 is able to buy only 20 Kg of potato.
Thus, inflation reduced your Rs. 100 to Rs. 80 next year (as it is able to buy only 20Kg of Potato next year) even when in paper, you find it as Rs. 100 note.
6. Rule 72 of Compounding/inflation
Rule 72 of Compounding/inflation means your money will get double or its value will become half in “72 divided by rate of return or inflation rate”.
7. Fixed deposits
When you earn FD at 5%, it will double in 72/5=14 years and that too if we neglect taxes and inflation.
8. Gold – Double your investment
In Gold, Real Estate etc returns are similar to inflation return in long term. So, it generally is hardly 7-8% across long period of times. This means, they will double in 72/7=10 years. But after we take into account inflation, net real rate of return is almost zero.
9. BONDS – Double your investment
In bonds, debt funds, if you get 8%, it will take 72/8 = 9 years for the money to double.
10. Mutual Fund – Double your investment
In MF, if you get 14%, it will double in 5 years.
11. Equity – Double your investment
In Direct Equity, if you get 20%, it will double in 72/20 = 3.5 years.
12. Risk – Guarantees returns or Guaranteed loss
Note that risk also increases with returns. But actually risk is not the lack of “guaranteed returns” but the risk of “guaranteed loss”.
FD Rate of Return is 5.5%
Nominal Rate of Return Post Tax @ 30% = 3.85%
Real Rate of Return in FD after accounting for inflation @ 7% = 3.85% – 7% = -3.15%.
Even, if someone is a retired person and paying no taxes, still, return will be 5.5% – 7% (inflation) = -1.5% which is still negative.
Also, for people who think, later FD rate will increase back to say 9%, pls note historically across all countries and economies, FD and Lending rates both keep decreasing across time and is in fact in sub zero levels for most developed countries. In India, it may not reach to that level of 1-2.5% levels in near future, it may also not go back to 9-12% levels also in future.
Moreover, even with earlier 9% FD return, post 30% taxation, return comes to 6% which after accounting for 7% inflation was actually a negative 1%. So, it was “guaranteed negative return” even earlier.
13. Investment – Real estate vs stock
So, if you invest say 1Cr in real estate for 10 years and get only 1Cr back or any stock price remains similar to its earlier price even after 10 years, then your actual investnent value is half (money value becomes half every 10 years due to inflation, calculated at 7%). Thus, your real return in above case actually is “-50%” even when, in paper you got Rs. 1Cr back.
14. ASSET CLASS
There are 5 kind of asset classes broadly.
a. Liquid Currency/Cash –
These gives zero nominal return and thus will keep on getting reduced every year by rate of inflation. Thus, Keeping Money stored in Locker is the biggest wealth destroyer in the world. Its value keeps getting halved every ten years, if inflation is at 7%.
b. Inflation Product –
These gives returns similar to inflation and grow due to inflationary pressures in economy. For example, Gold, real estate, crude, commodity, metals etc.
So, over longterm, generally, they will not generate any real return on your Investment but merely keep your investment intact by nullifying the effect of inflation for you.
For example, 10 Gm Gold value today is approx monthly expenses of any average middle class family. This was true for our forefathers and should be true for our future generations. This is true across economies and countries too.
So, gold does not give any real return but keeps our purchasing power intact.
Its NOT a Wealth Creation tool but instead it is a Wealth Preservation tool.
c. GDP Product:-
These products follow the GDP growth of a nation/economy. For example FD. What happens is when a country grows very fast, its businesses take more loans to make and sell more products for more profits. This leads banks to increase the FD rates for its investors so that they get more funds for giving as loans to businesses. That’s why, most developed countries where GDP growth is quite limited, leads to sub zero or even negative FD rates.
These are actually “guaranteed negative return products”, especially in case of high taxation, high inflation and low GDP growth conditions.
d. Inflation Plus GDP Product –
These are the only products, which are able to generate a reasonable, post tax, real returns and create wealth for you.
They give a min return of “inflation plus gdp” on a long term basis averaged for a min 3 years period. In India, inflation is 7%, GDP (except covid period) is 8% and thus return in such products are approx 14-15%. It is a average return so few asset classes here may give much higher or even lower returns too.
Example of such products are Direct Equity as well as Mutual Funds.
d. Speculative Products:-
These products actually go up and down depending upon supply, demand, liquidity and other reasons like privacy, unregulated market, cartel behavior etc. One should not keep more than 5% of such assets (if any at all) out of your total portfolio. Examples are Cryptocurrencies, few of Alternate funds, PE/VC Investment etc.
Conclusion with a story
Will end the article with a small story which every single investor may be able to relate with his life.
A grandfather who worked for all his life for one of the largest Public Sector/Government Owned Navratna Company, wrote a will that my whole savings should be handed over to my grandson after I am no more. This was his way to create a legacy for himself and handover Wealth to his future generations.
After many years, when the grandfather died, his grandson thanked him wholeheartedly for his kind gesture and started counting how much his grandfather’s total saving for his whole life of working in one of the best places in India generated.
What he found was:-
Average salary of Grand Father – Rs. 200 per month.
30% Saving (for that generation, not it’s much lower) – Rs. 60 per month saving.
Total saving for a year Rs. 6012 = Rs. 720 saving per year. Total lifetime saving for a senior officer of a Govt Employee (his grandfather) after almost 40 years of job = Rs. 72040 = Rs. 28,800 ONLY.
Alas, total life time legacy or saving of a well educated, hardworking, well employed and well salaried grandfather, who used to do all kind if cost cutting and savings in his life, was just not enough even for a decent large TV for his grandson.
This is the effect of your biggest enemy in life called “inflation” and it happened due to its power called “Compounding effect of time”.
It may not be any different for today’s or any generation, irrespective of their cast, creed, religion, country, economy, time period, background, private/public sector etc.
Only solution to come out of this trap is to earn above inflation returns and then use the same “Compounding effect of time” in your favor. This is a force large enough for Albert Einstein to call it “Eight Wonder of the World”.
Think of time as a huge magnifying glass. It will exponentially enhance whatever you will keep below it. Keep a small infant below this magnifying glass and it will give you a grownup man back. Keep a seed beneath it and it will throw back a whole tree for you.
Hope it helps in understanding the life and its rules in a slightly better manner.
Written by CA. Clifford D’Souza
CA Clifford is a passionate toastmaster and an intelligent Chartered Accountant. He is also a short term and longterm investor, do research on both technical and fundamentals of the scripts, and also guide many in the group for the stocks. Both for the short term and longterm stocks.