When it comes to saving and investing, people are obsessed with the returns they’re going to get on their money. Whether it’s debating the merits of a particular investment strategy, discussing the pros and cons of insurance, pensions and mutual funds (or increasingly unit linked plans) or simply searching for the best interest rate on bank deposits, it’s the returns that dominate people’s thinking – or the discussion with the intermediary.
And this is perhaps the main reason that an intermediary prefers selling National Savings Certificates, PPF, etc. which are not a high commission product (intermediaries make a net of 0.5% for a 7 year investment) instead of products like FMP (fixed maturity plans) even though the commission for the intermediary (0.5% for a 6 month period) is higher and the yield for the customer is higher (9.5% vs. 8% in NSC)!
This is perfectly correct, because, the better the returns you get, the more money you’ll end up with. There are a further two factors that determine how much money we end up with – the amount we put into our savings and investments in the first place and the amount of time we have it there. These two factors will have a far greater impact on how much money you end up with than mundane things like investment returns. For instance, let’s suppose that you need to cobble together Rs. 5 crores over 40 years and you reckon on getting an investment return of 12% per year.
If you pop the numbers in to excel, you’ll see that you have to save a paltry looking Rs. 3980 per month.
Now imagine that you spend an extra ten years of your life on the spending mode and you find yourself with just 30 years to get your Rs. 5 crores together. At the same 12% per year investment return, you’ll now have to save a difficult Rs. 14,000 per month. More than three times the monthly amount, although we’ve only taken a twenty five percent off our time period. What if we did fancy ourselves to get that higher investment return, which would surely get us to our Rs. 5 crores over 20 years.
Well at Rs. 14,000 this is not really a breeze now.
Well what about getting to Rs. 5 crores in 20 years with a smaller amount and a higher rate or return?Wouldn’t it? Well, of course anything’s possible, but to make up for the missed time, you’d have to almost double your investment returns. In fact, you’d need to get a return of 21% per year to turn Rs. 14,000 into Rs. 5 crores in 20 years!
Putting in your own numbers – Have a play on free website calculators with your own numbers. You will come to the numbers that you should be doing.Finally, you’d need to account for your investing costs. If you’re investing in the stock market via an index fund, then that might amount to 1% per year. If you’re investing via an actively-managed investment fund, then you’re charges might be more like 2.5%. The long-term returns, after inflation, from the stock market tend to be quoted at anywhere from about 12% to 44% depending on time period and a few other things like how enterprising your fund adviser is!
Any expectation (on current thinking) number that you hear above 16% is almost a fraud if suggested by your advisor, and foolish thinking if you start to expect it. So, for an efficient, indexing strategy, you’d want to be using a figure of 9% to 15%.
So that 12% I was using is, if anything, fairly ambitious. It would certainly be easier to argue for a figure of 9% per year than 12% per year. But error on the side of conservative side is seen as healthy rather than an error on the aggressive side. The long-term returns, after inflation and taxation, from gilts and cash are generally quoted as a little below 2% so, if you take away that 2% for average earnings growth you’re left with not very much.
As an illustration, to cobble together Rs.400,000 over 30 years with an investment return of 0%, you’d need to be saving Rs. 1,111 p.m. You get the same effect if your investing costs are too high.With so little to play with, it’s no accident that shares are considered better long-term investments than cash and gilts and it’s no accident that low-cost cash tend to work best.
So, plug everything in…So, you should now have a investment return to aim for, an amount of money that you need to reach. All you need to do now is have a realistic guess at how many years you have until retirement, plug in the numbers and hey presto, it’ll tell you how much you need to save.…and repeat the process regularly.
It’s important to know that these calculations only tell you what to do, given certain assumptions. Those assumptions are guesses at best and they’ll change regularly. For making a start this is good enough. The investment return you get might be different from predicted and the date of your retirement might get closer or further away. Most importantly, since we’re saving money in today’s money, we’ll have to keep increasing the amount we save to take account of inflation and average earnings growth.
Let’s go back to the original example in this article where we were expecting a return of 12% per annum and aiming to cobble together Rs. 5 crores over 40 years. To do that we set about saving Rs. 3980 pm. Now let’s fast-forward to 2012 and look at two possible scenarios – one good and one not so good.
Scenario 1 – Things go fine!
In the first scenario, we’ve actually managed an excellent investment return of 22% per year. That gives us a pot of investments Rs. 450,000 worth. The investment return is all the more impressive because we’ve only had inflation of 6%. Plugging the numbers in (a final value of Rs. 5 crores 35 years to get there, Rs. 4.5 lakhs already invested and a 12% annual return), we find we need to save Rs. 3500 per month to get us there! That’s a paltry fall of Rs. 480 per month! Inspite of the fact that we have got a cracking 22% per annum the amount that we should be investing falls by such a small sum. Again keeping a conservative mind set you should not be reducing the amount that you invest – you are just providing for a goal, so till the goal is near, changes are not recommended.
Scenario 2 – Things go, not so well –
In the second scenario, we’ve actually managed an investment return of 10% per year. That gives us a pot of investments worth Rs. 325,000 Again, inflation and earnings growth have amounted to 6%. Plugging in the numbers for this scenario (a final pot value of Rs. 5 crores, 35 years to get there, Rs. 3.25 Lakhs already available and a 12% annual return), we find that we need to put by Rs. 4800, again just a little more than what we have been investing so far. So really have things got harder for us because of the poor investment return that we managed? No. Our income has gone up much more, so paying this extra Rs. 820 is now a breeze!
Should you increase the investment? Yes absolutely.
Either way, it’s better than doing nothing
The gap between 22% and 10% is not small, is it? The impact is subdued because of the time frame that we are looking at – and the impact is marginal. So the rate of return though, important is not the be all and end all of investing. So, by repeating the sums on a regular basis, you can adjust your rate of investing to account for changing circumstances and how well your investments have actually done. Ideally, you should probably refresh the rate at which you’re adding to your savings and investments on about a once yearly basis. Both these alternatives have given us a return far in excess of a money market fund or any debt instrument currently in force in the country. Anyway, what you can see from both the above scenarios is the importance of getting started early.
Where things had worked well for the first five years, you’d be left looking to invest Rs. 3500 per month. Where things had gone badly, you’d be left saving Rs. 4800.
If you hadn’t started saving at all, though, you’d be left needing to save an unlikely looking Rs. 7650 per month.
So get investing now!
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