This formula is often used to calculate the returns some investment has given. The main concept in compound interest is that interest gets accumulated with the total principal amount and that interest again earns interest over the years. Which makes it very powerful.
Formula : A = P * (1+r/t)^(nt)
Where,
P = principal amount (initial investment)
r = annual interest rate (as a decimal)
n = number of times the interest is compounded per year
t = number of years
A = amount after time t
Example 1 :
Investment = Rs.10,000
return = 9%
investment period = 8 years
Total amount = 10000(1+.09)^8 = 19925.63
Example 2 :
Sensex returned 17.3% return over 29 years since its inception in 1979. What would be worth of Rs 10,000 invested that time.
A = 10,000 * (1+.173)^29 = 1022450.64 (10 lacs)
You can see that a small amount has actually grown to 100 times.
This tool is very important because it helps in comparing two differnt returns from two investments, you can calculate how much an investment has returned per year on compounded basis, Its just the opposite of Compound interest
Formula : CAGR = (A/P)1/n – 1
where:
A = Final amount
P = amount invested
n = Number of years
CAGR can be a great tool to compare two different investments and there returns.
Example :
A. 10,000 invested in a XYZ mutual fund for 2 yrs became 20,000
B. 50,000 invested in GOLD for 7 years became 4,00,000
Which investment has given more returns?
Here the main doubt is that how to calculate which one is better .. the amount, tenure is different. So in this case we calculate and see CAGR, one with more CAGR will be good.
This formula is very very important one, in our daily life we come across many situation where we do a fixed payment at the fixed interval, and we want to calculate the returns, but we don’t know how to do it .. Example can be
Monthly payments in Mutual funds through SIP
Yearly payment in a PPF.
Or any investment at a fixed inteval over some years. In that case we calculate the Final value using formula called Annuity.
Formula : A = P * [{(1+i)^n – 1 }/i] * (1+i) (if payment are being made at the start) (it will be P * [{(1+i)^n – 1 }/i] if payments are made at the end of the year)
Where :
A = final amount
P = installment each time
n = total number of installments
i = interest rate for that tenure (example if yearly return is 24%, but payments are made monthly then i = 24/12 = 2%)
Example 1 :
Robert invests 10,000 each month in a mutual fund for 10 years and the annual return was 18%, what will be his final corpus?
Here as payments are monthly, total payment will be 10 * 12 = 120
Vikas is planning his retirement, and planning to invest 5,000 per month in a Mutual fund for 20 yrs where he expects a return of 15%, then take out all the amount after 20 yrs and then put it in a FD for 15 yrs which gives him 9.5% return.
Here, we there are two parts
A. He makes monthly payment for 20 yrs (here we have to apply annuity)
B. then he takes the money out after 20 yrs and then put it in FD for 15 yrs (as this is one time payment, here we will apply compound interest)
A ) n = 240 and i = 1.25% (as the payment are monthly)
His money after 20 years = [5,000 * (1 + .0125)^240 – 1) / .0125] * ( 1.0125) = 75,80,000 (75 lacs)
Now he invests this money into a FD for 15 yrs at 9.5%.
B) Final amount = 75,80,000 * (1.095)^15 = 2,95,00,000 (2.95 crores OR 29.5 millions)
We are going to discuss today, a huge wealth creation by investing with discipline over long period of time. We often think that investing a small sum of money will not be able to generate huge Wealth and we need to invest huge amount of money.
Creating Wealth
Its obviously true that more money will create more wealth, but we are going to see today that we underestimate small savings and how small investments over a long period of time can generate fortunes.
How much wealth you can create, if you earn around $1000 /month (Rs.40,000 per month) and can invest 10% of that amount every month for next 30-35 yrs. I am assuming you are a 25 yrs old and retiring at the age of 60 (though i want to retire at 40). Total dependents are 3-4.
And monthly expenditure is Rs.25,000 ($600/month).
What kind of wealth can this person create?
Can he invest Rs 5000 ($125) in a diversified Equity Mutual fund per month till his retirement. I hope the answer can be YES
As we said that he is investing in Equities, What kind of return should we expect? 5% , 20% or 50%, but Wait … Equities are risky, it can be negative also !!! that’s very true … but People may not know that Equities are extremely risky in short term, but its almost not at all risky in long term, and if the long term = 35 yrs, then forget it, you can get some great returns.
Risk in Equities are inversely proportional to the investment tenure. Well that’s a different topic to talk about (And i will post an article on that soon , keeping an eye !!!) Just for the data, Indian Stock markets have given return of 17%+ CAGR return in 28 years, from 1979 (inception) to 2007. We are talking about Sensex.
So, to be safe we can easily consider 15% CAGR return in Long term (remember LONG TERM).
Coming to the point, It may happen that during initial years, our investor may face difficulty investing this much money considering, he may have other important things to take of and later he may have more responsibilities. But during is career life, his salary will also rise and then 5000 will be a small percentage of his salary.
So assuming he can do the investment we are proposing, what kind of retirement corpus he can build? Guesses?
I am sure most of the people will be thinking the following way:
He invested 5000 * 12 in a year, which is 60,000, and then he does it for 35 yrs , so he invests total of 60,000 * 35 = Rs 21,00,00 0 (21 lacs). And he will get some return of 15% every year. if we take 15% of this 21 lacs, it will be around 3,00,00, so total corpus = 24,000 and also as this is compounded , his interest will also keep growing at 15%, so it will be more than 24,00,000 , so lets take it 50,00,000. Fine …
Ok , let take 70,00,000 (70 lacs) to be safe. This is a calculation done not exactly by the proper annuity formula, but a workaround, which a general person can think of.
How much does he generate with this strategy
You can also look at my another article on Early investing and power of Compounding to get an idea about early investing and how compounding is a great tool. But keep going ahead if you are enjoying this article.
So the question is What will be his corpus , can it be anywhere near to 70,00,000 . The answer is that his actual Wealth will be way beyond this amount. After doing the actual calculation i can see that it will come around 7.43 Crores (Rs 74 million) .
But how is it possible , such a big amount !!! .
That’s because of compounding power . The interest earns interest and that again earns interest and this keeps on going. Initially the interest earned is very small , but as the time passes , the amount keeps growing and the interest also grows at an unbelievable amount.
Can you believe that this investor will earn more than 1.04 Crores only in interest in his 35th year (last year) , more than 4 times the money he actually invested whole his life. That’s all possible because of systematic and consistent investing with out fail and because of Power of compounding.
That’s the reason why one of the greatest ScientistAlbert Einstein said “Compound interest is the 8th wonder of the World”.
So it that all we are going to talk about today , NO !!! We have more to talk on this topic.
Why does this investor takes pain of investing that 5,000/month all this life. What if he invests just 10 yrs and leaves that money to grow for another 25 yrs. What if this is his plan till retirement.
The sudden thing which will come to your mind is that he invests for 35 yrs and created wealth of 7.43 crores , What if he just invests for 10 yrs .. it should be 10/35 * 7.43 crores = 2.12 Crores . Is that true ?
Will it actually be 2.12 Crores only. The answer is NO !!! . Then the question is how significantly different will his Wealth be in this case. The Answer is 5.88 Crores. Yes it will not be significantly less but just 21% less .
So Just by not investing for 71% tenure he actually gets 21% less money , that’s not a bad deal !!!
But wait , What if he wants that same 7.43 crores at the end , and still wants to invest for 10 yrs. the obvious way out is to invest more than his regular 5,000 per month . The question now is HOW MUCH MORE !!!
The answer is Rs 1420 more . Instead of 5,000 , he should invest Rs 6,420 per month for 10 yrs and then leave the money to grow for rest of 25 yrs. And he can generate wealth of Rs 7.43 Crores.
Watch this video to know how one can use Equity to create wealth over long term:
What we can learn from this
So there is a learning here and a very important thing to note , that more pain we take in the start , the better it is . In the initial years of career , its possible for people to invest more , as they have less responsibilities to handle and less dependents.
So it may be feasible for them to invest heavily in the initial phase of there career, which will benefit them for long term . Now see this person . Instead of investing 5,000 for whole of 35 yrs , If he chooses to take a little more pain in the initial 10 yrs and manages to invest Rs 1,420 more per month, then he can save investing for 25 yrs of his life and still can generate same Money.
One great question now !!!
What if our investor is ready to invest his 50% salary (20,000) per month for starting 2 yrs and then let it grow for rest 33 yrs. He is ready to heavily invest first 2 yrs of his career and do some sacrifices like not spending too much , no vacation , no fancy spending and all.
Can he still beat the target !!
Will he be able to generate the same Wealth for himself like in earlier examples !!
So here you go !!! , He will not only achieve the target , but exceed it.
His Wealth will be 9.24 Crores (Rs. 92.4 million) at the end of 35 yrs. I know that’s an Eye-opener . So now you know that the best time to invest was 5, 10 or 20 yrs ago , but if you missed it , don’t worry 🙂 . there is another golden chance and that’s NOW !!! .
please let me know what you feel about this article , that helps me to refine and write better articles.
People say its always a wise thing to Diversify your investments. Its gives you better security and better returns. It minimizes your risk and if one part of your portfolio is doing bad, it will not affect others and you will benefit from other side.
That is true, But then there are some things to note here.
Diversification – By investors point of view
Ask any investor who Started investing in Equities around 2002 and then sold his holdings at the end of 2007. If he sold it just by luck its great, but if he managed to take this decision based on his study on markets and hard work. Then its worth appreciating.
Diversification is very good, but only when you don’t have much time to track whats happening in things which you have invested in. Its a trade off between return and the time you can contribute tracking your investments.
What if you can watch your investments closely and take decisions based on any move in markets or investing world. In that case Diversification is not that important.
Warren Buffet’s views on diversification:
One of the greatest investors of all time Warren Buffet also says that Too much diversification is needs only when investors doesn’t know what he is doing. If you are cautious and well aware of things which affect your investments, then too much diversification is not required. Because you will take actions fast as an when required.
People who can not give time for there investments on daily or even weekly basis need better diversification. Read https://finance-and-investing.blogspot.com/2008/04/what-is-diversified-portfolio-and-how.html
to read more on diversification of portfolio.
Warren Buffet says that he likes to put his eggs in a single basket and watches it closely.
Lets take a Case study.
Ajay and Manish want to invest 1,00,000 each for 1 yr. During this period returns from different things were
Equities : 25% (for a year, but there were ups and downs in Equities market for whole year)
Gold : 20% Debt : 9%
Real Estate : -10%
These were returns after an year, so before making investment both of them did not knew that what will be returns.
Ajay do not have time to track his investments, but Manish has, so Ajay diversifies his investment like this/
On the other hand Manish do not diversify, because he has much time to track things closely, He does some study and understands that Real estate has short term bear market as there is lot of supply and interest rates are also going up which will affect demand and hence prices. He Invests most of his money in Equities and some money in Debt and Gold.
His portfolio looks like :
Equities : 80,000
Gold : 15,000
Debt : 5,000
His portfolio after 1 yr:
Equities : 1,15,000 (He sold his equities when he sensed that markets may fall in near term and then again bought at low levels, because of his good timings he earned more than 40% return)
Gold : 18,000
Debt : 5,450
His total = 1,38,450
Return = 38.45%
Conclusion:
Though this is hypothetical example, it shows that Because Manish kept a close eye on this investment, he does not need very highly diversified portfolio. He can have more concentration on something which he can closely track.
But risk can also be minimized by keeping a close eye on your investments, So the investor can choose more risky products and hence also increase there chances or earning higher returns.
Attaining financial goals is does not happen overnight, it needs a long term investment. But in case of Stock market, lot of people avoid a long term investment because of the fear of volatility of the returns.
Fixed Maturity Plan is the better option for such investors because of its higher security concerns. Let me explain you a bit detail about FMP.
What is FMP?
Fixed Maturity Plans are the equivalent of a fixed deposit in a bank, with a little difference. The FMP’s returns are only indicated and not ‘guaranteed’, Since the fund house knows the interest rate that it will earn on its investments, it can provide ‘indicative returns’ to investors.
Fixed Maturity Plans are debt schemes, where the corpus is invested in fixed-income securities.
Where do FMP’s invest?
FMPs usually invest in certificate of deposits (CDs), commercial papers (CPs>), money market instruments, corporate bonds and sometimes even in bank fixed deposits.
Depending on the tenure of the Fixed Maturity Plan, the fund manager invests in a combination of the above-mentioned instruments of similar maturity. Say if the FMP is for a year, then the fund manager invests in paper maturing in one year.
The expense ratio, generally varies from 0.25 to 1 per cent.
Tenure of Fixed Maturity Plan
The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment.
These FMP NFOs are generally open for 2 to 3 days and are marketed to corporates and well-heeled, high net-worth individuals. Nevertheless, the minimum investment is usually Rs 5,000 and so a retail investor can comfortably invest too.
Benefits of Fixed Maturity Plan:
1. Minimal risk – Fixed Maturity Plan’s are hold by fund manager till maturity which helps in getting fixed returns. Because of this FMP’s exposed least to the interest risks.
2. Protection from capital loss – FMPS’s invest in debt funds and this reduces the loss of capital relatively than that of equity funds.
3. Liquidity – Normally it is suggested to hold the Fixed Maturity Plan’s till its maturity, but if you want an exit then you will have that option and can exit from the FMP at any point.
What is the difference between FMP and FD?
FMP are differentiated form FD on the basis of some major key points like interest, returns, tax and indexation. As a debt fund, FMP enjoys the benefit of indexation on a long tern investment for more than 1 year.
FD is a risk free investment tool whereas FMP’s are risky because of the corporate debt default. Besides this, the returns from FD are fixed, but in case of FMP, the returns are only indicative and not fixed.
You can watch this video given below to know more about how FMP’s are different from FD’s.
Actual return Vs Indicated Return
The actual return can vary slightly, if at all, from the indicated return. Against that, a bank fixed deposit exactly prints the amount which is due to you on maturity on the FD receipt. However, FMPs do earn better returns than fixed deposits of similar tenure.
2. Investment in growth option of the FMP for less than a year :
The gains are added to the investor’s income and taxed at the investor’s slab rate.
3. Investment in the growth option of the FMP for over a year :
Either 10% capital gains tax without indexation or 20% with indexation.
What is indexation benefit?
The finance minister has been generous enough to recognize that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation.
The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.
FMP’s are investment options for sure if you want to park your money for short term. They are more tax efficient and give better post-tax returns. Though returns are not 100% guaranteed , they are almost risk free (remember almost) .
If they really give better than returns then FD’s and practically as safe as FD’s why don’t people invest in these ?
Ans : No awareness among people and they less risk taking attitude
If you have question or any doubt related to FMP, you can leave your query in the comment section.
Do you want to invest your money more safely? Here is one of the best options for you. ETF i.e. Exchange trade funds are one of the safe way of investing your money in equity market.
It is an investment fund traded on stock exchange, much like stock. These are attractive investments because of their low cost and stock like features. It offers both tax efficiency and lower transaction cost.
What are ETFs?
Exchange Traded Funds are a basket of securities that are listed and traded on a recognized stock exchange. Simply, they are mutual funds, whose units can be bought and sold on the stock exchange.
Given that an ETF is traded on the stock exchange, its price may not necessarily be the same as the NAV of the underlying portfolio. In other words, an ETF could have an NAV distinct from its market price. The reason being that the market price is usually driven by the demand and supply of units.
Hence there is a distinct possibility of an Exchange Traded Funds units trading at a premium or discount to its NAV.
For Example Nifty BeES , whose underlying is NSE , may not have same price as its underlying , For example if Nifty is 4500 , it may be possible that The ETF’s value is 4600 or 4400 , depending on the sentiments and expectations.
Watch the video given below to know the current status of ETF in India:
How does ETF work?
Exchange Traded Funds are just like stock exchange. For that you need to open a Demat account by any medium like through bank, online brokers or through any consultancy. Check for the prize value of the share so that you will know which of them are in your budget and then you can buy or sell your shares at any time you want to.
It is so easy like suppose you buy some shares at 10:30 in the morning and sell it at 12 pm. then again you can buy another shares after lunch.
Benefits of ETF
ETF’s are the low cost simple solution for the generating good returns from stock market investment. The benefits of ETF are as Given below.
1. Easy to access:
ETF’s can be purchased with just a single transaction. In EYF’s you are buying mini portfolio’s so it is way more easier than buying a basket of Indexes.
2. Cost effective:
Commissions are generally low on ETF as compared to the other tools. Besides this it there is no load fee’s and managing fee is also very low.
3. Transparent:
The most important thing of your investment is transparency. You should know where have you invested your money and how’s it performing. In Exchange Traded Funds, your portfolio details and underlying are publisher daily.
Difference between ETF and Mutual Fund:
Many beginners get confused between Exchange Traded Funds and Mutual Funds. Though ETFs are part of mutual funds, they are different in many aspects than Mutual funds. Lets see some of the differences between Mutual fund and ETFs:
ETF’s in India
Nifty BeES : Tracking NSE
Quantum Index Fund : Tracking NSE
ICICI SPIcE Fund : Tracking BSE
Bank BeES : Tracking CNX Bank Index
GOLD ETF’s or G-ETF’s
Gold ETF’s are the simple investments products that combines flexibility of stock investment and simplicity of Gold investment. Gold ETF’s are different from Gold savings.
IT tracks Gold prizes. Gold ETF’s are one of the best form of Gold Investments. Earlier investors used to invest in gold in metal form. Then comes paper bond and now you can invest in gold through electronic form.
BENEFITS OF GOLD ETF’S:
No risk of impurities.
Flexibility in buying Gold. Like one can buy in smaller lot.
Held in electronic form.
No storage cost.
No security concern like in physical form.
Transparent pricing and potentially cheaper.
Can track your investment values in real time.
No wealth tax like in Metal form.
Advantages of ETFs
1. ETFs tend to be more cost-effective vis-a-vis comparable mutual funds. The expense ratio of a passively managed ETF (tracking a benchmark index) would normally be in the range of 0.50%-1.00%; for an index fund, it can be as high as 1.50%. And for mutual funds the entry load is 2.25% .
2. ETF’s can be bought and sold anytime during the market hours , unlike the Mutual funds NAV at the end of the Day.
3. Given ETFs are traded on the stock exchange, and can be bought/sold on a real time basis; they tend to have low tracking error (deviation of ETF’s performance from that of the underlying index) as compared to index funds.
Disadvantages of ETF
1. Investors need to have a demat and a trading account, with a SEBI registered stockbroker, for investing in ETFs
2. Costly to operate – You need demat account to buy ETF and the charges for demat account might compensate the low expense ratio of ETF. One of our blog readers comments on that
While promoting ETFs it is argued that their 1% edge of expense ratio over mutual funds will be significant if it is compounded over a long period of time, say 20 years. So this advantage of less expense ratio is not there if the calculations in the previous comment are true. What I am trying to say is that the only advantage that ETFs have is that they are like mutual funds that will guarantee market related returns. Nothing less and nothing more.
If you have any query related to this topic you can leave your reply in the comment section.
1. Loss of money because of wrong decisions
2. Loss of potential profit because of lack of knowledge or having wrong information (I like to call it loss)
I personally feel and realized most of the losses happen to people because of the second point. Today after so much of progress, India Personal Finances still has some very immature characteristics. Indians have one of the highest saving rates in World, but we fail to invest our hard money in the best way.
What happened because of lack of knowledge
– Every insurance agent told that insurance is important, but not the best product for a person which suits him/her. They made Insurance policy synonymous with an Investment product to our average Indian. They packaged those Money back and Endowment policies as must have products for any married person with family.
– People love numbers, they love to get back 30 lacs back by investing just 10 lacs in a 20 years. They were never told about inflation, about decreasing purchasing power of money. Hence they can figure out that 30 lacs after 20 years is less than today’s 10 lacs, so actually they are getting cheated (yes, i like to call that cheated)
– Ask people what is an ETF, FMP, STP or REMF? Its like asking people what is LIC in 1957-58 or asking some one what is Mutual funds in early 90’s. These are important financial products of future, but people are not able to get benefited because of no knowledge.
– People who invest for long term (5-10+ years) still invest in FD’s and bonds, I don’t say that its wrong, but they do it because they don’t know that equity is best for long term, they know there is risk but don’t know that it almost no risk if they are investing in Equity for 10+ years.
When it comes to personal finance, people are almost clue less … Every one wants high returns but without any risk of loss. Everyone has heard about mutual funds giving 40-50% CAGR in 2005-06-07, but not even few know how what role did there excellent management and stock picks played to generate those returns.
Let me tell you what happens when you don’t know a lot of things.
See some of Real life examples :
Example 1 –
One of my classmate has taken ULIP, she pays 25000 per year as premium … She didn’t knew that there are high allocation charges of 18-20% in initial years… She didn’t knew that she can switch her investments in other safe options in ULIP if markets are down …
On the top of that she is given an Insurance of 1.25 lacs (i am not sure how it helps with her insurance needs) …
Example 2 –
One of my friend took LIC policy and pays 60000 per Annam as premium, he heard that it will save him tax … he did a great job in choosing the policy, returns are good … Insurance is fine .. but when asked if he has any financial dependents, he was clueless… I am not sure why the hell he took insurance at all then …
Example 3 –
One of my friend had put 100% of his investments (around 1.4 lacs) in Equity (80% shares and rest in mutual funds in early 2007 … when i asked on what basis he has invested all his money in Equity .. he said he needed good returns because this money will be used for his brother education in another 2 yrs …
I told him that they are risky and more than his risk appetite … he ignored it, saying that his money is almost grown by 70% already and gave him decent returns which he expected …. then came Jan 2008 crash and now his total investments are worth 80,000-90,000, he had invested in small -cap companies which gives nightmares to even great investment guru’s …
Example 4 –
Lot of my friends have invested in Mutual funds in lump sum in Dec 2007 or Jan 2008 and didn’t take SIP instead of my telling them several time that SIP is the the systematic approach and will bring down there average cost … and returns in volatile markets …
All of them have 30-40% loss at the moment, but all those who invested through SIP have loss of around 10-12% only … .
Example 5 –
I know many who earn good money, have good risk appetite and long term financial goals to meet … but they invest in what? NSC and Money back policy of insurance schemes … Any one who is out of his/her mind and is totally insane will invest in NSC or KVP in today time …
They take money back Insurance policy of 3 lacs or 5 lacs for 25 yrs or 30 yrs … I wonder how will that 5 lacs help them in 2035 when average monthly expenses of a medium class family will be around 1 lacs/month … they pay hefty premium of 30k, 40k or 50k in today’s time to get back the kind of money back after 30 yrs which will just pay there 1 yrs expenses …
They do it because they cant see not getting money at the end if they survive for all the money they have paid … they stay away from Term insurance because they don’t get any thing in the last .. So what if for 20 lacs insurance for 25 yrs they just have to pay 4200 total every year … they don’t get anything at last .. so better not to take term insurance .. its not giving anything … that’s what they feel …
Whats the solution?
It takes Rs.30 to buy “Outlook Money” and Rs.20 for “Money Today” (or read online : https://moneytoday.digitaltoday.in/index.php?latn=1 ) and 5-6 hrs to read all of it .
Just Rs.100 and some hrs per month can help anyone save thousands or lacs (depending on there investments), but it takes discipline and regularity
Today I am going to talk about something which is one of the extremely important tool for risk management and also something which is encouraged if you want stable returns from your investments. We are going to talk about the investments in Equity and Debt.
How Re-balancing the portfolio will help in –
Risk Management
Stability
Maximize returns
Understand the pros and cons of Equity and Debt
EQUITY
Pros : High returns, Low risk in Long term, High Liquidity
Cons : Risky, not suitable for short term investment
DEBT
Pros : Stable and assured returns, Good investment for short term goals
Cons : Low returns
Equity + Debt :
When we combine Equity and Debt, returns are better than Debt but less than Equity, but at the same time risk is also minimized compared to Equity and Debt, and when we apply technique of Portfolio Rebalancing, both risk and returns are well managed.
What is Portfolio Rebalancing?
The first step to understand is that each person must divide his investments into Equity and Debt in some ratio, it can be 40:60, 50:50, 60: 40, 75:25 or any ratio, The ratio depends on a persons risk taking capability and return expectation.
For an example let take the ratio to 60:40, portfolio rebalancing is nothing but rebalancing your portfolio in same ratio, in case they got changed after some months or years, as you wish. Preferably the good time is every 6 months or 1 yr, but not 15 days or 1 month.
Why Do we do it?
You have to understand that each person should concentrate on both returns and risk.
Case 1 : Equity:Debt goes up.
Action : Decrease the Equity part and shift it to Debt so that Equity:Debt is same as earlier.
Reason : As our Equity has gone up, we could loose a lot of it if some thing bad happens, we shift the excess part to Debt so that it is safe and grows at least.
Case 2: Equity:Debt Goes Down.
Action : Decrease the Debt part and shift it to Equity, so that Equity:Debt is same as earlier.
Reason : As out Equity part has decreased, we make sure that it is increased so that we don’t loose out on any opportunity.
Limitations Lets also talk about the limitations of this strategy, once your equity exposure has gone up, if you rebalance and bring down your Equity Exposure, you will loose out on the profits if Equity provides great returns after that, or if your Equity exposure as gone down and you bring up your exposure from Equity and if Equity does bad, then you will loose more.
Understanding the Game of Equity and Debt
But, we already said in the start that our primary concern is managing risk and profit is secondary. Let us understand that markets are unexpected and they can go in any direction, so better be safe than sorry. Many people are confused that if there equity has done very well then shall they book profits and get out with money and wait for markets to come down so that they can reinvest.
Portfolio rebalancing is the same thing but a little different name and methodology, so once you get good profit in something which was risky you transfer some part to non-risk Debt.
When we say Equity we mean shares or mutual funds which are related to Stock markets, which tend to go up and down, if it goes up, there are high chances that it will come down and when it comes down, its highly probable that it will move up again.
Lets us now see the most interesting part : Examples
Ajay has Rs 1,00,000 to invest and he want to invest it for 5 yrs and the 5 yrs returns are 30%, -35%, 40%, 60% and -30% .
Lets look at his money and its growth in 3 different mode
– Only Equity
– Only Debt
– Equity + Debt in some ratio (without Portfolio Rebalancing)
(click on this image to see in large resolution)
We can see here that Debt performed better than Equity, because of the uncertain movement in returns, also the Equity+Debt performed better than Equity but not Debt.
Let us now see the performance of Equity + Debt (with portfolio rebalance)
So now, every time our Equity and Debt ratio changes, we will rebalance it.
Ratio = 30:70
Investment = 1,00,000
Equity = 30,000
Debt = 70,000
At the end of 1st year (Equity return = 30% , and debt = 9%) :
Equity = 30,000 * (1.3) = 39,000
Debt = 70,000 * (1.09) = 76,300
Total Capital = 39,000 + 76,300 = 1,15,300
Now we will rebalance the portfolio
Equity = 30% of 115300 = 34590
Debt = 70% of 115300 = 80710
Now This is our new Equity and Debt investment
At the end of 2nd year (Equity return = -35% , and debt = 9%) :
Equity = 34590 * (1-.35) = 22484
Debt = 80710 * (1.09) = 87974
Total Capital = 22484 + 87974 = 110457
Now we will rebalance the portfolio
Equity = 30% of 110457 = 33137
Debt = 70% of 110457 = 77320
In this way we keep rebalancing the portfolio and lets see its performance for 5 yrs
(click on this image to see in large resolution)
Here, you can see that The column (E+D with PR) is the our main column which shows the performance with portfolio rebalancing. Here we have example for two ratio’s 30:70 and 70:30, we can clearly see that at the end of every year the final corpus for rebalanced portfolio was always greater than the non-balanced portfolio for both the ratio.
For ratio 30:70
Year 1 : 115300 vs 115300
Year 2 : 110457 vs 108517
Year 3 : 130671 vs 126142
Year 4 : 162424 vs 155595
Year 5 : 158039 vs 147452
For the 70:30 ratio also we can see that rebalanced portfolio outperformed the non-balanced portfolio.
Also you can see that for most of the years re-balanced portfolio outperformed “Only Equity” and “Only Debt” except 1st year and 4th year.
1st yr is very easy to understand why it happened and for 4th year, the returns were positive again after 3rd year and we made more profit in “Only Equity” portfolio because of high concentration on Equity side, but you can see that in 5th year, when there was a negative return of -35%, then the “Only Equity” fell heavily, but the rebalanced Portfolio fell very little because we have rebalanced it already and dropped our Equity Exposure to be safe.
Conclusion
So at last the question is what is the ultimate conclusion of all this talk.
Each person has his own Equity and Debt diversification, if the person is high risk taker his Equity component will be high else it will be less, every time your Equity and Debt component changes you have to see that it matches your risk profile, if it does not you bring it back to your level.
By bringing Equity exposure from high levels to your level, you are managing the risk you can take and by increasing the Equity exposure to your level back (in case it went down), you are making sure that you don’t miss out the chance.
Other reason is that Debt always increases, Every time your money goes up in Equity from your comfort level, you take that money which is earned by risk and shifting it to a safe place which will rise for sure though with less speed. Equity is linked with Stock Market and they tend to go up and down always and you don’t know when will it happen. So better manage that risk by Portfolio Rebalancing.
Please comment of this article to let me know how you feel about this article, Feel free to comment on anything which you feel is wrong .
Also, the example taken for this article was self made and does not represent any real life situation, but for sure its possible and similar scenarios have happened in our Stock Markets
The term health insurance is generally used to describe a form of insurance that pays for medical expenses. It is sometimes used more broadly to include insurance covering disability or long-term nursing or custodial care needs.
To understand it in simple words, you pay some amount of premium every year to a company and if some thing happens to you like an accident or if you have to through an operation or a surgery, they will pay for it provided, its covered under the Health Insurance.
Why do I need a Health Insurance?
This is the most common thing you can hear from a person who wants to avoid Health Insurance in India, but its one of the most important part of any ones portfolio or plans. People concentrate on the fact that what if nothing happens to them, but they fail to imagine the situation when some thing can happen.
Body is a complex thing, and no one knows what can happen in future, Even things like accidents is not in your hand, you can take try to avoid it, but what about others, what if some car hits you?
What if accidentally fell from some place? It can happen and it happens, and when you have to pay hefty bill for the treatment, you will realize that its a good idea to get covered by paying a small premium every year.
Consider this :
In Mumbai, businessman Manas Kumar rushed his wife Anita, 38, to hospital in January this year because she complained of breathlessness and shooting pain in the chest. Sure enough, it was a heart attack and Anita had to get an angioplasty done.
The cost of the procedure and stay at Hospital: Rs 1.5 lakh. But he didn’t have to shell out a single coin as he and his wife were covered under the Health Insurance with limit up to 4 lacs.
Why is Health Insurance more important now compared to earlier days?
Yes, Health care cost has increased many fold in last 20-30 yrs, Also now more and more younger people are complaining of Heart and other diseases which were seen in older people earlier.
Because of high stress jobs, bad eating habits and other similar problems, more and more cars in the city, pollution etc, the chances of getting some disease meeting with an accident etc have increased compared to earlier days.
More about Health Insurance
You get a good coverage for diseases and surgeries, so most probably you will be covered for most of the things.
You have to pay the premium which you can plan ahead and manage it, else if some thing unexpected happens, your finance gets in problem and impact your plans.
Also you get tax deduction under section 80D up to Rs.15,000 (Rs.20,000 for senior citizens).
You can also go for group insurance, its a ideal thing for a family with spouse, parents, kids … With group Insurance every one is covered and you pay less premium, also its more advantageous because there are many things which are covered in group insurance and not single person health insurance.
Make you buy a good cover which suits you, do good research and then choose the product.
If you want to save money it needs to be invested somewhere. But lot of people makes some mistakes in investing which seems very small at that time but they can prove a disaster to your financial life.
This is my favorite, because it is the mistake done by majority of people, Most of the people are highly under insured. By default, a person must be at least covered for 10-15 times his annual expenses. So a person who has a yearly expenses of Rs 2.4 lacs (20000 per month), must have a cover of around 25-35 lacs at least.
But they have insurance like peanuts, 2 lacs, 5 lacs, or 10 lacs. The biggest reason for this is that they take wrong type of insurance. Most of the people need Term Insurance , but they end up with Money Back plans.
to read more at :
2. No Diversification in Investments
Most of the people don’t pay good attention at diversification. They are either in Debt or Equity. They must understand that they have to diversify along different types on investments to minimize risks and also to boost up there returns.
Some people have only FD’s, PPF’s or NSC in there portfolio, then there are people who hold only Shares or mutual funds. While the former misses on the returns, the later on is exposed to high risk. Combining both of them can decrease risk, increase stability of returns.
3. Tax investment because of Last month rush and not Financial Planning
Most of the people rush for tax saving only in the month of Feb-March, when they get a letter from company saying that they need to submit proofs of investments under section 80C, and that’s the reason why people end up taking wrong products, just because they don’t have time to plan there investments. The best thing is to start planning for tax saving right at the start of financial year.
4. Starting Late
This is another big mistake people do, they do not start investing at the right time. A lot of time people actually can save some money but they feel that its not worth to save a small amount, they think that when they will be in condition of saving enough per month, that would be the right time to start, which is far from truth.
Watch this video learn more about 4 biggest financial mistakes:
Consider this:
Ajay Started his career at 22. He has worked for 8 yrs and now he is 30 yr old, He wants retire at 60, and can invest for another 30 yrs. He want to generate 4 crores for his retirement. He has 3 choices
1. 6000 every month for next 30 yrs.
2. Invest 10,000 every month for next 7 yrs and then leave it to grow for another 23 yrs.
3. Invest 20,000 per month for 3 yrs and leave it for 27 yrs.
Guess which choice will give him maximum money , The one where he is investing more for less years !!! . Yes .. The corpus generated is as follows:
1. 4.2 crores
2. 4.59 crores
3. 5.11 crores
So the idea is, start early and invest more … remember:
Start Early, Invest less = Start Late, Invest a Lot
Btw, Had Ajay invested 4,000 per month right from the time when he was 22, and invest for next 8 yrs and waited for that money to grow till retirement, He can generate more than 6.5 CRORES !! That’s better than all the 3 choices 🙂
Also see this example :
Considering return of 15% per annum from Diversified Equity Mutual fund, If you invest 10,000 per month for 10 yrs and then leave it to grow for 20 yrs, your investments worth will be 4.5 crores, But before that if you also invested 5,000 for 5 yrs and then 10,000 for 10 yrs, your money will be 7.5 crores.
One of my good friend had a small argument with me, that she would not invest in Term Insurance, because she will not get any “returns” out of it. I believe investing in a term plan looked a very unprofitable thing to her as she never gets back the money she paid as “premiums”, if she survives.
Endowment plans looked nice to her, because they provide money if you are dead and even if you survive. You get back money as the prize for not dying !!!.
With respect to Term insurance, she understood the fact that her family will get the money from insurance company in case of her death, but she was concentrating on the fact that she would not get back anything if she survives.
What is the return in that case? Nothing !!! and looked like some one is fooling you with a product called “Term Insurance”, where you are “investing” premiums to get nothing at the end.
Let me now tell why this happens and some give you some insight on this matter.
I have already talked earlier in my last post “Life Insurance and how to go about it”, about Term Insurance. Let me now take more deep dive into it and talk about the reasoning part.
I will first talk about fundamentals of Insurance and then talk about Endowment Policies and why are they popular, and what people don’t realize about them. and how Term insurance is the right thing for most of the people.
Basics of Life Insurance
What happens in a average family :
There is someone who earns and his family comprises of wife, kids, parents. if not all there is a subset of these family members. The head of the family earns and his family lives happily. All the expenses are met from the earnings of this main member, most of the time the husband. Now consider this person dies in an accident or for that matter because of any event.
What happens?
What happens to his family members other than the psychological trauma. If they don’t have money to take care for them selves, either some one from family have to take up the job and start working which may not be possible for them, or They have to decrease their standard of life to maintain the expenses.
They are now totally unsecured from future’s point of view. In short they are totally messed up, which should not have happened. I gave this detailed explanation for the circumstances because i wanted you to understand how bad can happen and proper measures must be taken care for this.
What is the Solution?
Adequate Coverage !!! this cant be compromised… You must have a backup plan which can give your family the same kind of income which confirms that they are not short of money in case the main earner is gone. If there are some debts like Home Loan, or any other tasks which need money apart from regular income, the cover must be good enough to cover that too..
For example :
Robert has a family expenses of 25,000 per month and there is a Home loan of Rs.25 lacs to be paid within 10 yrs. He is 27 yrs old. He has a wife, 2 kids and parents. All of them are dependent on him financially. He has investments of 5 lacs. Now in this case. In case he dies, who will take care of Home loan, how will provide them enough money to live life comfortably. They need 25k * 12 = 3 lacs per year.
Which they can get per month if they have 35-40 Lacs of money. If they put this in bank, they will get Rs.25,000 per month as interest which they can use. Considering inflation it will not be enough after some years, but lets leave it now for this example.
Add home loan of 25 lacs to this 40 lacs and what we come to know is that this family must be covered with minimum Rs 65 lacs . Rs 75-80 Lacs is a decent cover for this family. Now if he takes a cover of 80 lacs for his family, from that day he can happily live all his life without any tension , thinking what will happen if he is not there.
He will be attain peace of mind , and not be worried for it.
He must get a lot of internal peace because his Family is protected with a good enough cover to take care for them. And this is what you get in “return” from Insurance. No monitory return can give you more satisfaction than peace of mind.
So before doing anything else, his first step is to give adequate cover to his family and that’s the most important responsibility for him as a Husband, Father, Son. He must understand that this is not an investment for monitory benefit later in his life, but its for his family happiness and future.
Life insurance under MWP act is also one of the better option for married man. One point to remember and not forget is that this is the minimum cover required for family and anything less than this will be taking risk with family future.
Endowment or Money back Policies
Lets discuss the problems with these plans with respect to the above example.
High Premium : For an 80 lacs cover for say 30 yrs, the premium payable will be At least 2-2.5 lacs/year (this is a conservative figure). So now premium so high is not possible for anyone like Robert, so what they do?
They go with a kind of cover for which they can pay premium easily, can then they take cover for 5 lacs, 10 lacs or maximum 20 lacs. And guess who suffers in case of his death : HIS LOVED ONE’s.
It might also happen that they are compromising on a lot of small things which are important at that moment in time, like buying a bike for son, which they cant buy because of the insurance they have to premium, or some vacation they could have gone to with family, but compromise on that because of premium.
Money back at the end of the maturity is like a penny after so many years :
This is some thing most of the people overlook. They just see the numbers, 5 lacs 10 lacs or 20 lacs. And at the time of taking Insurance it looks good figure to them, because they see numbers, they dont see its value after many years, They don’t consider Inflation into account.
In case of above example, if Robert takes a cover of 15 lacs by money back policy, what happens if he survives the tenure. He gets 15 lacs at the end, Great Money after 30 yrs. Isn’t !!!
Lets see how great this money is? His monthly expenses will grow from 25,000 per month to 1.5 lacs per month (considering inflation of 6%). Now this money will help him survive for not more than 10 months … For so many years he pays high premium each year, just to get back money to cover his 10 months monthly expenses? What the hell !!!
Under Insurance :
Because of the fact that people want money back on survival and because of high premium, people end up taking policy for which they have to pay premium under there budget, which means less cover.
Without realizing the fact that they are highly under insured, the reason for this is that they see Insurance as investment product and not a protection cover for there family. When they die, there family get the money from Insurance company, but most of the time its not enough for them and it erodes very soon.
Term Insurance Policies
Lets discuss the features of Term Policies with respect to above example.
Cheap Premium : The premium is very low for Term insurance Policies. For above example. The yearly premium for Rs.75 lacs cover for 25 yrs is just Rs.20,000 yearly or just 1,600 per month !!! .
This is in any way affordable for most of the people. Its providing the fundamental requirement of Good cover and low premium and if you think of returns, Good cover and low premium can themselves be seen as good enough return. You family protection at low cost is the return you get.
Watch this video to learn more about Term insurance and it’s benefits :
Opportunity to invest rest of the money in High return Investments :
With term Insurance you save a lot of money in premium and now you can invest this money as per your wish in high return instruments, anyways in Endowment policies you put money for long term and you get it after so long time. So you can now always put your saved money in things which are long term investment products and return great returns.
One of those things is Equity Diversified Mutual funds and Direct Equity (depending on persons ability and interest). In long term Equity Diversified gives fabulous returns (15-20 yrs) and the risk is minimized because of long term.
And if you consider India growth story , it looks great in long term , hence Equities for long term is the most obvious choice. They will give you return of 15%+ CAGR. (15-20 yrs)
Also it will be flexible , you can not invest for a year or two, if you want to use the money for your family vacation or some important event.
Conclusion :
Insurance is not an investment product, its a Protection instrument for your Family or any one your want to cover. There are other products for your investments.
Let your finances be the way you want your life to be , SIMPLE !!!
Don’t mix Insurance and Investments. There are products like ULIPS(What are ULIPS) and Endowment or Money Back policies which never excited me. They complicate things, confuse people. They can be good if you understand how to make most out of it, but it require knowledge and expertise. They offer some flexibilities, but still they are not worth it.
Read more on Term Insurance at my Old article. I would be happy to read your comments or disagreement on any topic. Please leave a comment.
Disclaimer: All the opinions are personal and shall be taken as knowledge sharing and not as encouragement
If you have any query related to this topic you can leave your reply in the comment section.