Time (n) not returns (r) determines your wealth creation

this article appeared in Moneycontrol some time back, but (not surprisingly) not too many people appreciated it. Frankly this is one of the best lessons Independent Financial Advisors can teach their investors.

THERE are some word pairs that go hand in hand. When you say one you cant help but think of the other – eg. chicken and egg, carrot and stick, and so on. When it comes to investment, the only word that pops up is return.

No doubt, everyone invests for returns. That magic figure governs the fate of all investment products. The logic in people’s minds is simple: The better the returns, the more money you will end up with.

But it’s not that simple in reality. Returns are not the sole deciding factor of how much money you are going to make from your investments. Three more factors determine how much money you will end up with:

a. The amount you put into your savings and investments

b. The amount of time you keep it there.

c. Do you let it remain there and let it grow TAX SHELTERED.

These factors will have a greater impact on how much money you will end up with, rather than mundane things such as investment returns.

Here’s an example:

a. Let us suppose you need to cobble together Rs 5 crore over 40 years. With an investment return of 12 per cent per year you realise that you have to save a paltry Rs 3,980 per month.

b. If you deduct ten years from this horizon the figure automatically changes to a difficult Rs 14,000 savings per month – over 300% of the monthly amount today, although you have only taken 25% off from your time period.

c. Now you argue: What if you aim for a higher investment return? Surely then you can amass Rs 5 crore even in 20 years! You would need a fantastic return of 21% per year to turn Rs 14,000 into Rs 5 crore in 20 years.

Is that realistic? Consider this:

The stock market today is perhaps the only way you can reach your goal since it can give anywhere between 12% to 44%, depending on time period and how enterprising your fund adviser is.

Now, the charges of investing vary between 1% per annum to 2.5%, depending on the nature of fund management. So any expectation number you hear above 16% is almost a fraud if suggested by your advisor and foolish thinking if you expect it.

And in fact for an efficient indexing strategy, you should use a figure of 9 per cent 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.

And hold on! Taking into account inflation and taxation, from gifts and cash which is generally quoted as a little below 2 per cent, So, you are now left with a paltry 10% return!

So now plug in the numbers!

You now have an investment return to aim for, an amount of money that you need to reach and if you put in a realistic guess at how many years you have till retirement – hey presto! The calculator will tell you how much you need to save.

But remember:

i. It is important to know that these calculations only tell you what to do, given certain assumptions. These are guesses at best and change regularly.

ii. This is good enough to make a start. The investment return you get might be different from what was predicted, and the date of your retirement might get closer or further away.

iii. Most important, since you are saving money in today’s world, you have to keep increasing the amount you save to take into account inflation and average earnings growth.

Fast Forward 2012:

Let’s fast-forward to the year 2012 with our original numbers of Rs. 5 crores in 40 years with 12% rate of return and look at two possible scenarios: one good and one not so good.

Scenario I: Life is Rocking!

You manage an excellent investment return of 22% per year. That gives us a pot of investments worth Rs 450,000. The investment return is all the more impressive because we have only had inflation of 6 per cent.

Plugging the numbers in (a final value of Rs 5 crore which takes 35 years and Rs 4.5 lakh already invested at a 12% annual return), you need to save Rs 3,500 per month to get there. That is a paltry fall of Rs 480 per month.

In spite of the fact that we have a cracking 22% per annum, the amount we should be investing falls by such a small sum. You are just providing for a goal. So, till the goal is near, changes are not recommended.

Scenario II: Life is not all that rocking

You have 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 crore, 35 years to get there, Rs 3.25 lakh already available and a 12% annual return), we find that we need to put Rs 4,800, again just a little more than what we have been investing so far.

So, have things really 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.

In conclusion, the gap between 22% and 10% is not small, is it? But 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.

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.

What you can see from both the above scenarios is the importance of getting started early to minimize impact.
a. If all goes well in the first five years, you will want to invest Rs 3,500 per month.
b. If things go wrong, you would be left saving Rs 4,800.
c. However, if you hadn’t started saving at all, you would be left needing to save an unlikely looking Rs 7,650 per month.

So, remember now remember that Investment goes hand in hand with not just Return but also Time!

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One Response to “Time (n) not returns (r) determines your wealth creation”

  1. RaagVamdatt.com - Financial Planning Demystified on July 10th, 2009 at 8:56 pm

    Hi Subra,

    Excellent article… In their quest for returns, people often forget that compounding can work wonders over a longer time horizon – even if the return isn’t that great!

    Great points, and very well written. Thanks!

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