“No amount of reading or memorizing will make you successful in life. It is the understanding and application of wise thought that counts.” – Bob Proctor
This is the one quote which should be imbibed in our education system and in our lives. We have read and studied so many theoretical concept but very few of us understand those concept and fewer applies them in their real life. The below formula is probably one of those, which is read by everyone but applied by very few. This is one of the basic foundation of managing the portfolio but still not understood by many.
Amount = Principal x ( 1 + Rate of return ) ^ (Period)
Before we analyse our three levers of finance principal, period & rate of interest, Lets understand the lens through which we will analyse these. When i read the book by Stephen R Covey “The 7 habits of highly effective people”, the one concept that stuck with me was the circle of influence vs circle of concern. For those of you, who have not heard of this concept, I will share the quick gist of the concept. Circle of Concern is the events, news, people which affects us and the circle of influence is the acts and responses which are in control of ours. To be highly effective, One need to focus on the circle of influence vs the concern to take the right decisions. With some effort, education and changes, we can increase the circle of influence.
Now coming back to our Formula of compound interest, We all wants to accumulate money to serve our needs but most of the time we fail to understand the variables which are in our control vs the one which are not. Most of the investors are always have been the search of the best rate of return. I will get quizzed often to suggest the best stock or best MF or best asset class but very few times on any other aspects. Believe it or not but no one can do it with 100% consistency, Even Warren Buffet agrees to the same (Link).
We often discard the power of principal in the game of investing. This is one lever which is completely or at least to a large extent in our control but still least talked about. If i assume the common working/ saving life of individual, it will be 25-30 years and at a fix rate of 8% the impact of Principal as a factor can be see from the example. Person A investing 1,000 INR per month for 25 years @8% interest rate will be able to accumulate 9.5 lacs but if he is able to increase his investment by mere 5% every year he will be able to accumulate 15.4 lacs. The small change in principal by 5% can help him garner 60% higher final amount, Isn’t it fantastic? So, Please be aware and ask how much should i invest as one of your main question or Try to increase your investment amount as and when possible.
In a similar manner we keep forgetting the power of period which has a compounding effect on our savings. For example, if person A stays invested for 25 years with 1,000 INR per month or 12000 per year @8% then his investment of total 3 Lacs will mature as 9.5 lacs. While Person B starts late after 10 years, To invest same 3 lacs, he invests 20000 per year @8% for 15 years to get the maturity amount of just 5.86 lacs. The value of investing for long period resulted in 60% extra corpus and required smaller regular outflow. Therefore, Please make sure you make the full use of your investing life and stay invested for the longest possible period.
Lastly, Yes our favorite topic of discussion and obsession with the rate of return. The beauty of investment is that you can keep it simple or complex depending on how you like, I wrote earlier that looking for best investment return is a futile effort (Link). We should aim for the minimum required return and work toward those by managing our portfolio (Link). If you are expecting the YoY return of 12-13% by investing in equity think again as they are neither promised nor consistent. But as you educate yourself and learn few things you can increase your circle of influence to generate better returns. for e.g. Investing for longer period in equity can help you reduce the risk of loss. In below chart you can see that for 1 year investment you return can be anywhere from -60% to +105% but as you continue to hold your investment to 3 or 5 years the chances of losses as well as exorbitant high returns reduces.
There are otherways to improve your chances to secure better returns which we will continue to discuss. Till than continue to focus on the other two levers as well instead of just staying obsessed with returns.