Chapter 1: Basic Concepts
Savings, Borrowings and Investments.
A long time ago when I was a kid…
On one sunny day that I still have fond memories of, my father came home in the evening with a toy pig. I turned it around and discovered that it had a hole in its back. My dad announced that it was my ‘Piggy Bank’.
He fished out a 10 paise coin from his pocket and instructed me to put it through the hole in the pig’s back. I did it eagerly, expecting the pig to start walking. Walk it didn’t but my father patted me on my back and said,
“Son, this is your first saving. I will give you 10 paise everyday and when we have collected Rs50 we will go to the bank and get you a savings account.”
Savings! suddenly a new activity had begun in my life that I understood nothing about.
My Dad noticed the puzzled look on my face. He scratched his head and suddenly a meaningful look came in his eyes. I think he remembered the ant menace that my mom had been complaining of for the past few days. He showed me the ants that were carrying grains in a line to their hiding place.
“The ants are carrying grains and saving it for a rainy day, he said.
He took out my World Book Encyclopedia and showed me various other animals that save food for a time when they may need it.
“You know that I go to office to earn money for all of us. But when I turn 58 years, I will have to retire and stop going to office. We will need money to buy food and clothing even after I retire from my job and stop earning. I need to save now, so that I can pay for our food and clothing later,” he explained.
“Similarly, you can save the money I give you now to buy a good book or a paint box later,” he impressed upon me.
That was my first lesson in ’saving’.
A few years later I learnt in my class that all of us have two choices. We can consume now or can consume later. Hence, savings is just postponing consumption.
Does it then mean that only what we consciously keep aside for a rainy days is called “saving”?
“No, what ever you do not manage to consume and stays as a surplus is also ’saving’. But that is a lucky state to be in,” my teacher responded.
And that set me thinking…
“If I can ’save’ to consume at a later date, I can also spend more now if I know that I can earn enough surplus to pay for it later…”
Just then my teacher’s booming voice interrupted my train of thoughts…
“Borrowing is the opposite of saving,” she announced.
Now that was easy to visualize.
I had a classmate who was fairly irregular to class, spent a lot of time in the school canteen and supposedly even bunked classes to watch the ‘matinee’.
How did he manage to pay for all his nefarious activities?
Well, he used to borrow money from a few friends of mine who saved their pocket money.
During the break, I manage to accost one of those friends who had lent money to my classmate.
“I can understand why Ramesh (by the way, that was my classmate’s name) borrows from you. But why do you lend him money? Can he pay back?”
“Look, I don’t really intend to spend all my pocket money. I am saving up for a new cycle. Money always burns a hole in my pocket. Hence, I lend it to him,” he answered.
“Ramesh has a rich father, who is a family friend,” he explained. “I know that I can get my money back. Ramesh also knows that when he turns 18 he will look after his family business and earn well. And then he will have no time to have the fun he is having now. Hence, he borrows to spend,” he added.
Learning for me again
‘Saving’ is not consuming everything today and leaving something for tomorrow whereas ‘Borrowing’ is consuming more than what one has today, expecting to save more later to pay up for the excess consumption now.
While ’saving’ is being conservative and wise, ‘borrowing’ is being risky and foolish unless for a basic need. Hence, it makes sense to borrow only when one is sure that in the future he will be able to save enough not only to pay up for his borrowings but also to see him through the days when he cannot earn.
What is ‘investing’ then?
This question bothered me till I had my first mug of beer from some bottles that we had smuggled in from my friend’s place (it belonged to his father who owned a liquor shop).
Oh boy! I loved it so much, the beer I mean. But soon an idea suggested itself to me. If everybody starts liking it, the demand for beer is definitely going to rise. The growing population will ensure that the demand sustains. Wouldn’t then it make a lot of sense to set up a company to manufacture beer? If demand drops then my friends and I can very well step in!
I had grown up finally from the days of aspring to be a bus conductor to wanting to own a beer factory now!
The next day, I started discussing my ambition with my friend’s father. During the course of our conversation I learnt of the money needed to buy the fermenting equipment that can produce beer for years to come.
By selling all the beer that can be manufactured, I can recover the initial money spent on the business by the end of three years. Beyond that, the money that I’ll make will be surplus. That would be an awful lot of money.
Of course, I remembered that as ‘Investment’ from my economics textbook.
In other words, ‘Investing’ means building up to meet future consumption demand with the intention of making surpluses or profits, as they are popularly known.
Investments are risky
True, what if tomorrow everybody decides that ‘beer’ is yuck. Maybe the government will ban beer consumption. Or your plant might develop a big problem for all you know. Hence, there has to be a reasonable profit expectation to motivate an investment.
Also, when you or I ‘invest’, we forego our present consumption or do it out of our surplus. In other words, ’savings’ again supports ‘investment’.
Interesting isn’t it?
We started with three things that looked as different as chalk, brick and wood, but discovered that the three (’saving’, ‘borrowing’ and ‘investing’) are related.
But then, I have a few questions in my mind already. I am sure you would have some too.
What if I save Rs1000 over 10 months to buy a cycle and the price of the cycle shoots up by 20% by then? I am losing the ‘purchasing power’ of my Rs1000. Is there some way I can make up for the risk of losing my purchasing power?
Getting a little complicated for now. Let us unravel it later.
?
2.What’s behind Inflation? I love my gandfather’s stories. Who doesn’t? We won’t get into the ones that my grandma loves to scoff at. Like his brave encounters with tigers. Or the one about the milk that needed boiling.
But you must listen to this one. My dear grandpa used to buy 10l of milk for 50p and 40kg of rice for Re1 a good fifty years ago!
Don’t believe me? Then sample this. In those days, there were coins of 1p and even less! Incredible, eh? But I have seen those with my own eyes in my father’s collection of old coins.
What more, I also remember seeing and transacting in 5p and 10p coins in my childhood. Alas! my son won’t get to see those currencies. Except in an collection of old coins perhaps!
Wondering why I am rambling about 1p coins and getting into the generation business?
This is not a “Kal Aaj aur Kal” story. Or maybe it is.
If you have an eye for detail you will have noticed the common thread that runs through these anecdotes. The point that I have been trying to make is how expensive things have become over the years.
My grandfather used to buy 40kg of rice for Re1 and today a kilo of rice costs Rs20! 10l of milk cost 50p in his days but today you need at least Rs120 to purchase the same amount.
See what the passage of time has done. It has eroded the value of money. Having Rs800 today is equivalent to having Re1 fifty years ago!
Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The ‘purchasing power of money’ is the amount of merchandise that a unit of money (say a rupee) can buy.
And the term ‘inflation’ has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called ‘inflation’. This is manifested in a general rise in prices of goods and services.
But why do prices rise?
Let us understand why this happens with the help of a simple example:
Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.
Let us assume the onion crop fails in a particular year, for whatever reasons.
What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions.
Remember November 1998? Such a situation actually happened in several parts of the country. It nearly brought down the government! The price of onions rose to as high as Rs40 per kg or more.
But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sutained fashion?.
In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this set off a chain reaction.
How?
Think again. It is not only onions that we consume in the course of a day. There is a whole basket of products and services that we draw on, on a day-to-day basis.
Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21″ TV with 100 channels.
And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car…
We could go on and on, but you get the idea,don’t you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can ‘inflation’ lead to prosperity?
We are posing a lot of questions. Do not worry we will come back to answer them later. Write in at school@sharekhan.com to tell us. Maybe we will use your response itself!
But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time – saver, borrower and investor.
Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie.
What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.
In short, inflation is one BIG enemy of savers.
So, why should we save?
A good and important question. But we will come back to it later. We need to find out how this monster they call ‘inflation’ impacts our two other friends.
We have already discovered that ‘borrowing is the opposite of saving’. So if the saver is losing, our borrower must be winning.
Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather’s neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!
To top it all, the borrower spends NOW and adds to the inflation effect, doesn’t he? And compounds the misery of our saver.
What about our last friend, investor, the slightly difficult one to understand?
Imagine once again (just one last time, we promise) that my grandfather’s friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at Rs20!
Our investor friend seems a lot better off than even our borrower who benefits from inflation.
No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call ‘hedging inflation’.
Hey, but what is happening? Last time we understood that the saver, borrower and investor are good friends who complement each other. The saver meets the needs of the borrower and the investor. Life is in perfect harmony.
Now you are saying that ‘inflation’ upsets this balance completely. That the ’saver’ is at a complete disadvantage while the other two benefit from this poor guy.
Is life so very unfair? Should we all stop saving? Or have we missed something very fundamental?
Well, life is never unfair. We have a leveler who comes to the aid of the saver – interest.
Next time, we’ll discover how interest offsets inflation and puts our saver on an equal footing with the borrower and the investor.
3. Getting even with Inflation
Time to take stock of things before we continue with our journey.
We have made three friends so far – Saver,Borrower and Investor.
Saver, like many of us, saves now to consume at a later date, when he may not have an income to meet his various needs. Hence, he saves for the rainy day.
Borrower, on the other hand, spends more than his means allow at a given point of time. He hopes that he will earn enough in future, when he will not only repay his creditor(s) but will also have enough money left to spend on food and other necessities.
Investor is the person with a glint in his eyes. He invests in a business that is essential to us all. He hopes to sell his products year after year. Of course, we figured out that he is the one who takes the big bets.
Interestingly, all of us keep switching roles from Saver to Borrower or even Investor.
We have made another discovery – the ‘purchasing power of money’ declines with time, thanks to the monster called Inflation.
Interestingly, Inflation bares its fangs only at Saver. It is a saviour of Borrower and a boon to Investor.
We have also learnt an important lesson: Investing is a good way to offset Inflation.
After understanding all this, we stopped ourselves to ask if it is worth saving.
We realised that something was missing from the picture.
And then, a bolt from the blue told us that it is ‘Interest’ that completes the big picture.
Question hour again
So, what is Interest? Why do we need it? How does it tilt the balance in favour of Saver?
Too many questions and all will be answered in good time.
Let us first assume you have Rs500 to spare. You have two options as to what to do with it – you can either buy a shirt today or you can save the money and buy a shirt six months later, during Diwali. Mind you, the same shirt will cost you Rs550 by Diwali time. So, what do you do?
You are obviously muttering: “what a stupid question!” After all, it will make a whole lot of sense to buy the shirt now as your Rs500 will not be able to fetch you the same shirt six months down the line. And why save anyway?
Hold your horses while we add another twist to the options that you have.
Assume a friend of yours needs Rs500 urgently. He is willing to return Rs550 six months hence. What will you do then?
Well, if he is a very good friend you will give him the money and postpone your plan to buy a shirt. After all, you can buy the shirt once your friend returns your money.
Another twist: what if your friend promises to repay Rs600 (instead of Rs550) six months down the line?
You will lend him that Rs500 without any second thoughts, as you will not only be able to buy the shirt six months down the line, but also have Rs50 to spare.
Lessons
1. It does not make sense to save if you have not been compensated for Inflation.
2. In order to boost your saving instinct, you need to be compensated at least for the loss of your purchasing power. That is you need to be compensated for Inflation.
In our examples, we have seen that a borrower is willing to repay a higher sum in order to compensate the lender for the loss of his purchasing power.
Some very basic arithmetic now
In the first example, you lend your friend Rs500 but he returns Rs550 six months later. That is your friend gives you Rs50 extra when he returns your money. In the second case, he returns Rs100 extra. The money that you lent him is called ‘Principal’. The extra money that your friend gives is called ‘Interest’.
‘Interest’ defined the textbook ishtyle
“Interest is the price paid for money lent by one person for the use of others.” In other words, Interest is in no way different from wages that are paid as a price for the use of labour.
What is Interest Rate then?
Interest paid on principal expressed as a percentage of the principal. Hence, in our second poser, Interest Rate was 10% (Rs50 interest on a Rs500 principal). While Interest Rate in the other example was 20%.
Now we know what Interest Rate is.
The battle lines have been drawn
Interest Rate aids Saver by compensating for the ravages caused by Inflation. On the other hand, Borrower has to think twice before borrowing since he needs to pay a price.
What about Investor?
Investor now starts having second thoughts too.
He uses money to set up a business. Last time, we discovered how uncertain investing can be, as many things can go wrong with the business. However, the expected rewards (profit) offset the risk (uncertainty) and hence, Investor goes ahead.
However, now he has the option of earning Interest on his money if lends it to Borrower. Which is why he needs to make at least as much profit as he would have earned as Interest if he had given the money to Borrower.
The cycle is complete now.
When Inflation rises, Borrower and Investor have a distinct advantage.
Borrower rushes to borrow more to spend now while Investor smells higher profit from its business. Saver knows that he is at the receiving end and insists on higher Interest Rate, reestablishing the balance.
Pack up time
We have learnt how Interest swings the balance of power back in Saver’s favour. Interest induces saving.
4. Investments vs Savings
I lost all my savings in the stock market scam of 1992.
Do I hear other murmurs that say –
“I lost all my savings in the panic that ensued after the nuclear tests in 1998.”
“I lost all my savings when CRB Capital markets shut down.”
Or if you want something current then try –
“I lost all my savings in the ‘New’ economy meltdown of 2000.”
Make no mistake- these are painful statements. All through our lives, we have been repeatedly advised that we must save money for a rainy day. And when we did just that, some of us have suffered the misfortune of losing it all.
A penny saved…
… is a penny earned is what I was told by my favorite English teacher in middle school. Unfortunately that penny doesn’t get us very far anymore. Nobody told me about the silent enemy called inflation that could lay waste to the coin that the tooth fairy left under my pillow. Incidentally I was also taught how to calculate interest by an excellent but stern Mathematics teacher. But at that point I did not comprehend that it (interest) was my best weapon against that stealthy enemy (a simple preference for English over Mathematics?).
Realisation dawns
In High School I was introduced to the dismal science of economics and the world of basic finance. Thats when it all fell in place – the way to safeguard my savings from inflation was to put it in the bank or invest it somewhere. So that I could earn a rate of interest higher than inflation and protect my money.
Life rolled on
I entered the workplace at the age of 22. The saving habit came naturally to me. What with all those sayings ringing in my head – a penny saved…
I was determined. I wasn’t going to let that sneaky character ‘Inflation’ get at my savings. No simple bank deposits for me – I was going to beat the hell out of inflation by investing my savings profitably in the stock market. In fact, I would beat the rate of inflation by a wide margin. I was too cool for my own good. And with impeccable timing, I caught the concluding part of the great Harshad Mehta orchestrated boom (caught in the Bulls’ tail!). But I caught the full impact of the downdraught that followed the famous boom. The rest is history.
Some more…
My financial situation or shall I say penury as a result of that debacle taught me some more lessons that none of my English, Mathematics or Economics textbooks had. A new host of aphorisms pored forth- No free Lunch, No pain-No gain…
You see it is true that you must save for a rainy day. But what follows, as a natural corollary is that to protect your savings against inflation you must invest it in some asset that will earn you returns. Be they shares, debentures, bonds, gold or even real estate.
And therein lies the crux of the issue. All these investment options have been associated with rags to riches as well as riches to rags stories. So – Investing is a risky business. The higher the return you expect from your investment, the higher the risk you will have to take. Your savings are not savings anymore. When you decide to invest your savings you are crossing the Rubicon threshold. Your savings have now taken the form of Risk Capital.
Risk capital?
Yes, because that is what it is. Don’t panic at the thought. You could put your money in a government bond or in a NSC and that would qualify as almost a zero risk investment. (Actually it is just the lowest risk investment available to you, but that’s the topic of another debate). And at the other end of the spectrum you have equities, which come with a high degree of risk. So do Gold and real estate. But we’ll discuss that some other time.
It’s time to step back and spell out what I have learnt
• Savings is the difference between Income and Expenditure
• You must save for a rainy day
• Savings have no ‘form’ and must be protected from Inflation
• When you invest your savings it has morphed into Risk Capital
• Risk Capital can be eroded
• Risk can be minimized by choosing to invest in low risk investments
• The risk associated with each investment changes with time, and must be monitored carefully.
The take home from all of this is that the Rubicon must be crossed. And this is not a Catch-22 situation. Yes you must invest to protect your savings from inflation but that need not necessarily place your financial future at jeopardy. There are low risk investments that exist in the market place. You can structure your investments based on your appetite for risk.
Words of Wisdom
I am now wiser. Wise enough to encapsulate all of this into my own saying – ‘It is not how much you save but where you invest it that counts’ – Sharekhan circa 2000.
By the time you get to this point in the write-up, you may be feeling just a wee bit nervous about your savings. Nay, Investments. Don’t. At the end of the day, Investing your Savings is like falling in love. It can be risky and it can hurt, but that doesn’t stop us from falling in love does it? For the heady and glorious experience….
The old adage, “its better to have loved and lost than never to have loved at all” may assume a new meaning.
5. Value of time with Money
Remember our three friends – Saver, Borrower and Investor and their tryst with Inflation?
Inflation is detrimental to Saver but favourable to Borrower and Investor.
But this lop-sided scenario can’t last forever. Saver can’t always be the ‘poor guy’. And Borrower and Investor can’t benefit endlessly at his expense.
We surely know why. If things continue as they are, then all of us would want to be borrowers and investors! And nobody would bother to save!
So, the stage is set for a new character, who would balance the disequilibrium. Enter Interest, the great balancer.
Interest tilts the balance in favour of our friend Saver, thereby levelling the playing field for our three friends. But how does he do that? Saver demands interest for postponing his consumption while Borrower and Investor have to pay up Interest for using Saver’s surplus.
Hence, what Saver loses owing to Inflation, he gains through Interest.
Now that we have seen how Interest restores the balance, it is time for us to move on…
Assume that your friend calls and offers you Rs1000. He says that you can have it either now or tomorrow. What would you choose?
Pretty simple, eh? Your voice is loud and clear as you say, “I want now.”
Just in case you choose to have the dough tomorrow, do let us know at school@sharekhan.com
So, why did you choose to have the Rs1000 NOW?
You obviously are thinking of the many things that you can do with that money. You can buy a couple CDs or a pair of new jeans or even the pair of shoes teasingly displayed at the shoe shop on the way home. After much deliberation, you decide to go for the pair of shoes. With the cash in your pocket, all you need to do now is go to the shop and buy.
However, your friend is too busy and is unable to give you the money today, but he promises that you will get it a month later. You are sorely disappointed. All your plans of buying that pair of shoes lie shattered.
“Or what if somebody else buys those pair of shoes, which may well be the last such pair on earth?”
“Or what if your friend delays his gift by another month?”
‘If’ – the root of all uncertainties! What we commonly term as ‘Risk’ and what can ruin all your well laid plans…
Hence, if you have a choice, you would rather go to see this friend at his office and collect your money today.
Why would you do that?
This brings us to a fundamental truth: Time has value.
We all know that the value of a rupee does not stay the same across time horizons. Due to Risk and Inflation, a rupee today is worth more than a rupee tomorrow on the time line.
In simpler words, we are saying that the value of the same rupee differs at different points of time. This difference in value arises due to the passage of time. Hence, it is called the ‘Time Value of Money’.
Expressing this in numbers, if you believe that you can buy the same pair of shoes with Rs1100 a month later, then the time value of money for you is Rs100 for a month.
Twist in the tale
Now, let us assume that your friend actually turns up and gives you Rs1000. But while on the way to the shoe shop you meet your old classmate who badly needs Rs1000. In that case, will you part with the money?
You would, provided he promises to return at least Rs1100 a month down the line, so that you can buy the same pair of shoes. (We know that, in real life, you would not take a penny more than what you have lent to your classmate, but just for academic purposes!)
So, what do you call this extra payment that you demand over and above the amount you have lent?
If the answer is ‘Interest’, you are right. But then what is Interest? And why is it charged?
Let me explain. When you are lending the money to your friend, you forego an opportunity to buy the shoes and use them when you wanted. Hence,you would charge the cost of losing this opportunity, commonly termed as ‘Opportunity Cost’, to your friend in the form of Interest.
One last exercise before we bid goodbye to ‘Time Value of money’ and ‘Opportunity Cost’ for now.
What is the Opportunity Cost for our friends, Saver, Borrower and Investor?
Saver:
Saver is a lot like you. He needs to get compensated for the erosion in his purchasing power with time as also the risk associated with postponing consumption.
Borrower:
Now that Saver has an ace up his sleeves in the form of Interest, Borrower needs to evaluate his decision to borrow and consume now. Why? Now there is interest to contend with.
Lost? If your classmate is borrowing Rs1000 from you today to meet his needs and is repaying Rs1100 a month later. Then, he is better off fulfilling a need of his that will be worth at least Rs100 more a month later.
Investor:
Our most enigmatic friend, Investor has several opportunities knocking at his door. He can set up a beer factory or open a restaurant among other things. We could actually exhaust this page writing about the options that he has staring at him. As we all know, our clever friend hopes to maximise his profits and minimise his risks.
In case he decides to set up a beer factory, the profits he would have earned by setting up a restaurant are considered as his ‘Opportunity Cost’!
He also has a very basic ‘Opportunity Cost’. He can opt to lend his money to Borrower in return for Interest payment. Thus his investment needs to fetch him enough profits to compensate for all this.
Hence, Investor needs to know the value of his future profits in today’s terms for all the investment opportunities. Only then can he make the best choice. This brings us to another vital concept: ‘Present Value’.
6. Power of compounding
“Compound interest is the eighth wonder of the world”
- Benjamin Franklin
“Compound interest is the world’s greatest discovery”
- Albert Einstein
“In case you earn Rs20,000 per month, do you know how many years it will take for you to become a Crorepati? Not 10 or 20, but 50 years!” exclaims Amitabh Bachchan, the anchor for “Kaun Banega Crorepati”.
Mr Bachchan, did you know that if you invest just Rs9,250 once and earn 15% per annum on this investment then, in 50 years you will be a ‘Crorepati’ too!
And in case you invest Rs20,000 every month for 50 years under similar terms, you will be worth more than (hold your breath) Rs173cr! That is Crorepati 173 times over!!!
Welcome to the ‘Power of Compounding’
One of the basic premises of investing is that your money multiplies manifold over time. And this multiplication of money is normally referred to as the “Power of Compounding”.
So, how does money compound?
When you invest money, it earns interest (or returns, if you may). If you keep the interest invested, then it does not sit idle while only the original investment sweats it out. The interest earns interest too! And then the interest on interest earns interest again!
That is the beauty of compounding. That is what made great men like Albert Einstein and Benjamin Franklin extol the virtues of ‘compounding’.
What does the ‘Power of Compounding’ mean to an investor?
Ms Thrifty, Mr Realist and Ms Follower went to the same school and the same class.
On her 10th birthday, Ms Thrifty’s father gave her Rs100. She wisely invested the money that earned her an interest of 15% every year.
Mr Realist won Rs200 as prize money when he was 16 years old. His friend, Ms Thrifty, advised him to invest his prize similarly.
When Ms Follower earned her first salary at the age of 21, she salted away Rs400 in the same investment.
After reaching the age of 60, all three decide to withdraw their investments. Who do you think realised the most from his/her investment?
You think it’s Ms Follower, right? After all, she invested four times the money that Ms Thrifty had invested. So what if she invested the money 10 years later. She did earn interest for 40 years anyway after that.
But think again. Ms Thrifty makes the most out of her investment! In fact, her Rs100 is worth Rs1,08,366. On the other hand, Ms Follower’s Rs400 is worth Rs93,169!
It simply means that the LONGER you stay invested the MORE you make.
Now you know why Ms Thrifty made more money than Mr Realist and Ms Follower.
Let us try another small exercise.
Let us assume Ms Thrifty, Mr Realist and Ms Follower invest Rs100 for 10 years. However, all three of them earn interest at different rates. Ms Thrifty earns 20% while Mr Realist earns 15% and Ms Follower manages a 10% interest rate.
Can you work out what each one of them will have ten years hence?
Ms Thrifty will have Rs619 while Mr Realist, Rs405. Ms Follower will have the least – Rs259 in ten years. Did you notice something though? While the interest rates differ by just 5%, in 10 years the worth of the original capital, Rs100 was vastly different!
That is another way of understanding the ‘Power of Compounding’ or the power to grow exponentially.
Now that we have understood the magic of compounding, it is time to take a look at an interesting rule associated with ‘compounding’ – the Rule of 72.
The ‘Rule of 72′ is an easy way to find out in how many years your money will double at a given interest rate. Lost?
Suppose the interest rate is 15%, then your money will double in 72/15= 4.8 years. In case, the interest rate is 20%, then the money will double in 3.6 years.
Interesting rule indeed!