Month: October 2016

Lesson #8: Mutual Funds: There’s something for you too!

I hope that you could manage to go through last week’s post about investment avenues. If you really did, you are highly likely to find this post interesting.

Let me tell you, rather bluntly, that what you will be seeing in the lines below, may sound little academic, rather class-room types, but trust me, sometimes it’s indispensable. On that note, wish you a happy reading!

Mutual funds came to public attention only in the late 1980’s or so, when fund investments touched new highs and their returns sky-rocketed. Just as other great inventions, the mutual fund (hereafter, MF) has had rather humble beginnings. People often cite the birth of the first MF in Netherlands, at the hands of a Dutch merchant Adriaan van Ketwich in 1774. You will be surprised to know that Ketwich named his fund ‘Eendragt Maakt Magt’, which translates to ‘unity created strength’ in English. You will soon see why.

What are Mutual Funds?

Mutual Funds represent a collection of small savings of several different investors that are invested together by a professional mutual fund manager. This means that while the money or the saving is yours, you don’t get to choose where to invest directly, primarily because of lack of time or expertise or both on your part. This lacuna is overcome by the appointment of an investment expert (called the MF Manager) who shall decide where to invest the total pool of funds, in a manner that generates the maximum return on the amount invested. Whatever is earned is passed on to investors, after deducting some amount for the manager’s fee and other fund expenses. Simple.

Are all Mutual Funds the same?

No, they are not.

Every fund has its own stated objective (mentioned clearly on its offer document, also called the Prospectus), which its manager is expected to pursue. For instance, some funds may aspire to achieve growth, while others may look for periodic cash returns etc.

Given that different funds have different investment objectives and strategies, every investor has a great variety to choose from, in terms of his own risk preferences and investment objective.

Advantages of Mutual Funds:

Personally speaking, I believe that MFs are the way forward for almost every economy of the world today, given their massive potential to tap into small household savings and meaningful, professional investment.

Some advantages of MFs can be summed up as under:

1. Professional management: Most small investors comprising people like you and me, lack the expertise to identify safe and viable investment options. This is addressed by MFs through their hiring of professional fund managers, who are expected to choose the best investment options, keeping the broad investment objective of the fund in mind. In fact, not only are funds expected to disclose the names of their fund managers in their reports to investors, past performance of other funds managed by the same manager can also be found. This can act as an important factor in deciding whether one’s money is in safe hands. Also, one should, as far as possible, stay away from funds that have had frequent changes in their fund manager over time.

2.Economies of scale: Just as in case of any other investment, MF investment too entails several costs, such as entry and exit loads, transaction costs on purchase and sale of securities etc. The pooling from a large pool of investors has the effect of dividing these costs over all of them, thereby reducing investment costs per person, compared to investing on one’s own.

3.Diversification: Has anyone ever told you to “not put all your eggs in the same basket?” If not, let me tell you that today. By putting all our eggs (think of your savings) in the same basket (think of a particular share or bond), we risk losing everything if something goes wrong with that one avenue of ours. MFs allow you to invest in a variety of securities in different sectors and industries, thereby insulating you from excess exposure to a particular stock or sector. Even if one sector does badly, some other sector may end up doing well, guaranteeing you your average expected return. This is called ‘diversification’.

4.Liquidity: Just like a savings bank accounts, most MFs provide almost hundred percent liquidity, allowing you to withdraw your money from the fund, at any point of time.

5.Simplicity: Once entered into, MFs are easy to track and review. Periodic statements from funds come in handy in deciding whether to continue with the fund or exit.

6.Regularity in savings: Most people believe that only the rich, or those with large amounts of savings can invest in MFs. This is, however, only a myth. Most MFs provide you the option of a Systematic Investment Plan (SIP) that enables you to invest an amount as small as Rs. 500 every month to the fund. This encourages regularity in savings, without hurting the pocket.

7.Tax benefits: Certain MFs, also called Equity-Linked Savings Schemes (ELSS) provide tax benefits on sums invested in funds under section 80C of the Income Tax Act, 1961.

Disadvantages of Mutual Funds:

1.Agency problem: This stems out of the fact that sometimes, the fund manager may not work in the best interest of the investors, whose money he is managing. He may feel that despite poor fund performance, he may continue to be paid his fees. This creates adverse incentives. However, choosing funds managed by reputed managers may alleviate this concern considerably.

2.High costs: Maintaining and running a MF is a costly affair. Everything, ranging from the manager’s fee to the cost of printing periodic fund performance statements entail costs, which is ultimately passed on to the investors.

Types of Mutual Funds:

While there are a hundred varieties of these funds, it may be helpful to understand the broad classes of funds:

A.Based on investment strategy:

1.Equity funds: These is the most common fund type, representing those that invest their entire corpus of funds into buying shares (also called stocks) of other companies. These can further have sub-types such as index funds, specialty funds etc., discussed in subsequent sections.

2.Fixed-income funds: Remember debt instruments from the previous post? To help you recall, Debt comprises instruments such as corporate bonds and debentures that help generate periodic interest payments, without significant risk to the principal amount invested. These funds invest their entire corpus in fixed-income or debt securities, thereby assuring their investors of fixed cash inflows (through interest) and low risk to the amount invested. Given the certain cash flows, these are often preferred by the retired population or pensioners.

However, here too there’s a catch. Please remember that not all bonds are safe! There are also bonds that represent money-raising by highly risky companies who may not be able to even return your capital, forget the promised interest. Such high-risk bonds are often referred to as ‘junk’ bonds. Good name, right?

3.Money Market funds: These involve investing in very short term debt instruments such as Treasury bills. Without much damage to your brain cells, simply try to remember that Treasury bills are certificates issued by the Government, making them almost hundred percent safe, in terms of expected recovery of both principal and interest. These funds therefore, offer you safety of your money, albeit with comparatively low returns (does this ring a bell? Remember the risk-return trade-off?).

4.Hybrid funds: This in itself is no category. It simply implies an investment strategy in more than one category mentioned above. For instance, think of a fund that invests 70% of its money in equity and the balance in debt. That’s what a ‘hybrid’ fund is.

B.Based on investment focus:

1.International fund: As the name suggests, these funds focus only on investing in stocks of foreign companies. They must, however, be distinguished from Global funds, which invest in any part of the globe, including your own country. Some people are of the view that such types of funds are more risky than domestic funds, given the political risks associated with different economies.

2.Regional funds: While these may sound similar to International funds, they have a uniqueness of their own. These represent funds with a particular geographical focus, such as investment in only the Latin American region or say, the western parts of Germany etc.

3.Sector funds: These invest only in particular sectors of the economy, such as banking, automobile, financial services, manufacturing etc. Given their narrow focus on particular sectors, their performance depends directly on that of their respective sectors, making them highly risky and volatile.

4.Socially-responsible funds: Also known as ‘ethical’ funds, these try to strike a balance between profitability and ethical standards, by choosing not to invest in specific industries such as tobacco, nuclear power and alcoholic beverages.

C.Based on liquidity:

1.Open-end funds: This is the most common category of funds. These, being the most liquid, allow an investor to ‘cash-out’ at any time, i.e. withdraw his funds by returning the units held to the fund, at any point of time, at the Net Asset Value (NAV, explained later).

2.Closed-end funds: Unlike open-end funds, these issue units only once through an Initial Public Offering (IPO). While you can enter only at the time of the IPO, you can ‘cash-out’ only when you have been able to identify a buyer for your units. This means that you can transfer your units to another person and not to the fund itself.

3. Exchange-traded funds (ETFs): These combine the features of open-end and closed-end funds, representing funds whose units are listed (just like shares) on an exchange. Listing ensures high liquidity – you are almost always sure of finding yourself a buyer when you wish to sell and a buyer when you with to enter the fund.

D.Others:

I have used this residual category to include funds which, I felt, did not fit in any of the categories above:

1.Index Funds: These represent funds that have a rather simple and clearly-stated investment objective – to beat a particular market benchmark, such as the Dow Jones Industrial Average (DJIA) or the SENSEX. Given this, the investment manager simply attempts to replicate the market index. These funds are often associated with low fund fees.

2.Balanced funds: These typically fall in the category of ‘hybrid’ funds, as they combine the high-return feature of Equity with the safety feature of Debt. A typical fund of this class may divide its assets between Equity and Debt Instruments in a 60:40 ratio.

Some terms you may want to know:

 Just like every other subject, the MF business has its own terminology. While it may run into several pages, let me talk to you about only two of them, which I deem to be most crucial:

1.Net Asset Value (NAV): This is a metric used to evaluate the financial health of a fund over time, or simply to compare several funds. It refers to the difference between the market value of the assets of the fund and its liabilities (hence the term NET assets), divided by the number of unites of the fund outstanding . Note that units of a fund represent something very similar to shares of a company. Investors park money in a fund through purchase of its units. Every unit-holder is a part-owner in the fund.

2.The Expense Ratio (TER): Just like the NAV for performance measurement, the TER helps an investor understand how costly the operations of a fund are. It usually comprises expenses such as manager’s fee, administrative costs, marketing costs of the fund etc. Higher the TER, lower the returns to the investor.

As we end:

MFs are a powerful tool, offering something for everyone. All one needs is clarity of investment objectives and scepticism in selecting the right product for oneself, to be able to gradually advance towards a more secure future.

Once again, I apologise for the humongous size of the document, but you know it’s difficult to keep shut, particular when you know that omission of an important concept may inhibit understanding for the reader. Also, with this post, I think that the Personal Financial Management series is gradually drawing to a close with may be another couple of posts on say taxation and budgeting.

I would love to hear from you – any suggestions and feedback is welcome!

Thank you for reading. See you next week.

Image taken from Google images.

 

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Care for a ‘selfie’?

I’m not too sure why I’m treading on this territory, as in expressing an opinion on something that may not be too socially value-adding, while putting me at high risk of being judged for being too opinionated.

Actually, I write this piece not so much to opine, but to also clear the grey clouds that seem to have settled (rather permanently) on the little grey cells in my brain. This dilemma has been caused by something as ‘innocuous’ as the trending selfie fever.

The word ‘selfie’ was declared the ‘word of the year 2013’ by the Oxford dictionaries, which defines a ‘selfie’ as ‘a photograph that one has taken of oneself, typically one taken with a smartphone or webcam and uploaded to a social media website’. Phew!

Wait – there’s more to it. To those who think that selfies are only about weird facial expressions or about sparrow-like pouts, let me tell you that there are various types of selfies, each dedicated to different parts of the human body (yes, I’m serious!),  different activities and different situations. For instance, you have a ‘helfie’ for the hair, a ‘belfie’ for the posterior (yes, though I’m not sure who wants to see them!), a ‘foot-fie’ for the feet, a ‘welfie’ for a workout selfie and a ‘drelfie’ for your drunken self, a ‘groupfie’ and a ‘we-fie’ for a group of people. Please do not be surprised if I tell you that the last two words I just finished mentioning, i.e. groupfie and wefie are registered trademarks of Chinese phone manufacturer Huawei and Samsung, respectively. I won’t steal them mobile manufacturers – be assured. Last but not the least, are words like ‘shelfie’ and ‘bookshelfie’, for items of furniture. Kudos to such creativity!

Before I take you through a tour of my own thoughts about this business, let me guide you through some other information, which just like selfies, stares you right in the face. The American Psychiatric Association (APA), has declared taking ‘too-many’ pictures of the self as a mental disorder, which they call ‘selfitis’ (as if the jargon above wasn’t enough!!). In fact, the APA, as also many other psychiatric associations, associate the obsession of clicking selfies, to ‘narcissism’, which simply refers to an obsession to the self.

To define the intensity of the selfie mania, they also lay down three categories of selfie-taking, based on the clicker’s tendency to click and post on social media:

  • Borderline: Clicking at least three pictures of the self per day, but NOT posting on social media
  • Acute: Clicking at least three pictures of the self per day, and ALSO posting on social media
  • Chronic severe: Clicking at least six pictures of the self per day, and ALSO posting on social media

But why do people click selfies in the first place?

The APA advances largely two reasons: to make up for low self-esteem and to seek approval from the world. Really?

In fact, even if we leave aside the psychological aspect of the selfie business, it has been and continues to be a serious threat to people’s physical security. Every now and then, we hear instances of people drowning or falling in potholes or men electrocuting themselves on top of trains while clicking pictures of themselves, unaware of their surroundings. In fact, in the year 2015, it was reported that more people were killed while taking selfies, than due to shark attacks. Oh boy!

Now let me tell you exactly why I’m talking about this. Do I looooooove clicking selfies of myself or do I detest it to the core? You know, it’s often an extreme emotion that makes us think of something in so much detail, which of course is also the case here. While I neither love nor hate the selfie concept, it does make me creepily uncomfortable. I’ll tell you why.

Of late, I have observed a large number of young men women , let me call them ‘youngsters’, lest they get offended, struggling to jut out their lips in just the perfect ‘pout’, in a frantic attempt to click selfies, at just ‘that’ right moment! I pity the poor beings as they spend (‘waste’ would be a better word!) minute after minute, in adjusting and re-adjusting their lips, in possibly different directions and angles, and finally share it on some social platform and then keep checking their phones once in every thirty seconds or so, to see what a giant wave their picture has created. Trust me, I have seen this happen on dinner tables in restaurants, in movie halls, sometimes in classes I teach, pretty much everywhere.

While I have no problem with the lip exercise or the unnecessary movement of the facial muscles, my worry stems out of mainly two things – wastage of precious time and the self-damaging need to seek social approval.

Time is a precious resource, largely because it is limited. You know, one day, a wise woman told me something so worldly-wise, that I have resolved to take those words with me to the grave. As I was trying really hard to juggle with time to keep people happy, she said “For those who are related to you as mere acquaintances, do not hesitate in spending money, for that shall suffice in making them happy. But on those you love and who love you back, spend your time. Money can’t please them”. It was that day that I realised that truly, to people who matter to me, my time matters much more than anything in this world that I possess.

Also, in one of the earlier posts I had written, I had mentioned about my infallible tendency to undertake a cost-benefits analysis (a CBA) in anything and everything I do. It simply means that before spending any useful resource (like my time, energy and of course, currency), I compare the costs with the benefits. If I believe that the benefits of doing something exceed the costs, I go for it, else I forget about it. It’s the same thing when you spend your time. If I spend twenty minutes in clicking the perfect selfie, one that hides my double-chin, conceals the pigmentation on my face, magnifies my tiny eyes, and highlights my cheek bones, can even a hundred likes on some social medium justify that amount spent? Well, I don’t think so, at least in my case.

To put it another way, how do those likes on may be Facebook help? All they do is, they make me feel better about myself. They make me feel more accepted in society. They make me feel good. But then what after a day? The warmth of acceptance dies out and the self-confidence begins to fade, and the anxiety sets in again. What do I do now? Click another one and see if people still like me? Am I still loved and accepted? This goes on and on and on.

To me, therefore, the selfie business is not a disease, but merely a symptom of a bigger illness, of something rotting deep inside. The very fact that I ‘need’ acceptance stems from the fact that I have not really accepted some aspect of myself. How can someone expect acceptance without self-acceptance; or may be happiness without contentment or worse, respect without self-esteem? One cannot. At least not by faking conformity to contemporarily accepted social standards.

So why don’t we just try and be ourselves, even if for a while? Let me tell you out of experience – it’s totally worth the effort.

Try it!

Image taken from Google images.

Lesson #7: The Art of Investing: Transforming Incomes into Assets

For all of you out there, who have been following the Financial Management series, this post might prove the most useful, in terms of hands-on practical guidance to basic investing. So far, while we talked about analyzing incomes and expenses, generation of savings, we stand finally at the last leg of the saving process – Investment. Simply speaking, Investing is the process of making money work for you, i.e. parking money in avenues which enable our savings to multiply over time, through the power of compounding (remember?).

Before we get into the how’s of investing, let’s spend a couple of minutes on understanding its basic premise – the risk-return trade-off. Sounds weird, isn’t it? But it’s actually the most intuitive financial concept one can acquire.

The Risk-return trade-off:

A trade-off is a situation that requires you to choose between alternatives, because you cannot have both. Similarly, this concept states something absolutely fundamental – ‘no return without risk’ OR simply, higher the risk, higher the return and vice-versa’.

This implies that for more conservative investors, who fear losing their money, returns on investment shall be limited (rather low). However, for risk-loving investors, who are willing to lose their money in adverse circumstances, returns shall be higher. Another way to look at it is: if you want high returns, you will have to live with high risk to your investment, else be satisfied with lower returns. Another lesson that stems out of this concept is that please beware of schemes that offer high (rather unbelievable) returns on relatively low-risk investments. Such schemes are generally fraudulent, and designed specifically to dupe uninformed investors.

Remember: no one, and I repeat, no one can double your money overnight! If they could, they would be relaxing in some luxury cruise in some remote island of the world, and not be selling you that nonsensical scheme!

Knowing your Investment options:

As I start this section, I see myself opening a can of worms. I say this because there is so much to say about this that given the space constraints, I’m baffled as to what to write and what to omit. Also, to ensure that the average reader benefits from this writing, rather than pluck his hair in frustration, I choose to keep things short and crisp, while attempting to provide a bird’s eye view (a larger picture) of all that exists out there. But even then (as you will shortly realize), this article spans six pages on my Microsoft Word file! Therefore, my suggestion to you would be to read this article in parts, stopping each time your eyelids get heavy with sleep.

Coming back, broadly speaking, I would like to classify investment options into three large heads: Banks, Debt and Equity. The finer details within each category have been elaborated.

I.Banks:

We all know what these are, right? Obviously. But let me give you a different lens to look at them. Banks are financial institutions that engage themselves in collecting deposits from the public and lending that money out to others who need it. While depositors are paid an interest on the deposits they keep with the bank, people and corporates availing loan facility from the bank are charged a rate of interest. Naturally, the interest the bank charges (income for the bank) exceeds the amount of interest it pays to depositors (expense for the bank), generating profits for the bank (incomes minus expenses). Therefore, the bank essentially plays the role of an intermediary, i.e. a party that bridges the gap between savers (people like you and me) and borrowers (again people like us, plus corporations).

In terms of parking our money with banks, we can usually do it by opening an account with a bank of our choice. Accounts can be of two types: Savings accounts (the most common) and Current accounts.

Savings accounts: These are maintained by individuals seeking safety of their money and high liquidity to ensure easy withdrawal. Since money can be withdrawn any time (through cheques, or ATM cards etc.), the risk element in such deposits is usually low. Hence, return continues to be low, around 4% per annum (per annum or p.a., though scary to read, implies ‘per year’).

Current accounts: These are generally maintained by corporations and other business entities to avail of certain facilities such as bank overdraft. A bank overdraft is an added advantage provided by the bank wherein the account holder can withdraw more than what he has in the bank account, a rather common business situation. Overdraft, therefore, is in the nature of a bank loan, on which interest must be paid to the bank.

Investing with the bank:

There are broadly speaking, three options:

1.Savings deposits: This simply refers to the amount you have parked in your savings deposits.

Pros: Safe, highly liquid, easy to withdraw

Cons: Very low rate of interest

2.Recurring deposits: As the term indicates, these deposits require you to deposit a fixed amount every month for a certain number of years. At the end of the stipulated period, you receive a lump sum amount (principal plus accumulated interest), which is way higher than the total of all that you have paid into the deposit, thanks to the power of compounding.

Pros: Safe, ensures regularity in savings, easy on the pocket every month

Cons: Not very liquid. Entails a penalty on non-payment or premature withdrawal.

3.Fixed deposits (FDs): These are most commonly held by domestic savers and households. These require a one-time deposit with the bank, for a fixed period of time. On maturity, the sum (principal plus interest) is received by the depositor. Generally, FDs pay around 8-9% p.a.

Pros: Safe, high interest.

Cons: Illiquid. Entails a penalty on non-payment or premature withdrawal. Hard on the pocket, especially in case of large amounts.

II.Debt instruments

I’m glad I have reached this section. It’s something I love to talk about and also something which must be carefully worded. So here we go.

What is ‘debt’? It simply is the acknowledgement of indebtedness by a party.

Whaaaaat?

I mean to say that ‘debt’ is a promise by one party (the borrower) to pay another party (the lender), a fixed sum of money (principal), on a fixed date (maturity), along with interest at fixed intervals.

‘Debt’ is in the nature of a contract, wherein the borrower must pay back the lender, his principal as well as a fixed sum of interest every period (say six months or a year), as remuneration for the sum lent.

As an investment option, ‘debt’ is beautiful. Yes, beautiful.

The beauty of debt lies in the fact that it provides you with completely safety through:

  • An assured return (promised periodic interest payments) AND
  • Certainty of receiving your principal on the maturity date.

Now let’s talk about the most commonly available debt instruments in the market – Bonds.

Bonds:

Ever wondered how companies raise money? In fact, to most of us, the very fact that corporations (or companies) also need to borrow money comes as a surprise. Just like us, even they need funds for purposes such as expansion, building new plants or undertaking a new project etc. But then how do they get this money? Simple – from us.

In order to raise funds, companies usually issue shares and bonds, which we must buy, for them to be able to receive their money.

Let’s talk about bonds here. We shall take up shares in the next section.

Let’s say a company needs Rs. 10,000 for a new project. It approaches a bank for funding, which rejects its application. Now the company decides to issue bonds in the open market. To enable investors of different social strata to participate in its funding, it divides its entire borrowing need of Rs. 10,000 into 100 bonds of Rs. 100 each (100 bonds X Rs. 100 = Rs. 10,000). Let’s say 100 different people in the market go out, pay the company Rs. 100 each and buy 1 bond each (note that there is nothing to stop an investor from buying more than one bond). Now the company has managed to sell 100 bonds of Rs. 100 each, thereby being able to receive Rs. 10,000.

What about the people who bought the bond? Each of those 100 bond-holders are now creditors or lenders to the company, who are entitled to received fixed interest payments every period (rate of interest and periods of payment are determined by the terms of the contract) as well as repayment of principal amount at the maturity of the bond. The beauty of being a debt-holder is that you shall receive your promised interest payments even if the company under-performs in the market, i.e. whether the company makes a profit or a loss in that period! Isn’t that great?

Pros: Safety of principal, fixed income every period through interest payments, legal recourse in case of default.

Cons: Low returns compared to equity markets

III. Equity

Have you heard people talking about making or losing money in the stock markets? Or about cashing out may be? What they are referring to is ‘equity’ shares.

Unlike bonds are debentures, which raise you to the position of a company’s creditor or lender, equity provide you ‘ownership rights’. Wow! Isn’t that exciting? Well, it is, but it comes with its own set of risks.

Just like bonds, shares are issued by companies to raise money from the public. To facilitate wide participation in the issue, their entire fund requirement is divided into a large number of shares of a small denomination, usually Re. 1 or Rs. 10. Anybody and everybody who holds even one share is a part-owner of the company. But, unlike debt, equity comes with high risk, both in terms of returns as well as repayment of principal.

Equity shareholders are not paid any fixed amount every period, instead a ‘dividend’ whenever the company does well and the management decides to pay out cash to the shareholders. In case the company does not do well or when the company is short on cash, no dividends shall be paid. Also, in case the company is shut down or liquidated, the creditors shall be paid first. If anything remains, payments shall be made to equity holders. This implies high risk.

Really? Then why invest in equity at all? No certainty of dividends and even principal? What the hell?

Well, remember the risk-return trade-off?

As you would have seen by now, equity involves high risk. You never know whether you shall see your money again, but in times of good performance by the company, equity rewards you like crazy. Think of a highly profitable company that is still left with piles of money after paying its creditors. Such companies usually choose to pay out huge amounts as dividends to their shareholders, as a way of rewarding them for the risk they bore and for their support in times when the company needed funds. So do you see the difference now?

While creditors receive interest with certainty, the amounts to be paid to them are fixed, no matter how well the company does. But while equity is uncertain, there is no maximum amount you can make! Sounds like a lottery, isn’t it? Well, it is sort of that. Except market experts, who regularly track markets and know how to carefully identify market signals, we, as relatively-less informed individual investors must be careful in choosing to buy individual shares without adequate market research.

Just for your knowledge, share prices, just like any other commodity, depend upon the forces of demand and supply for a particular share. For instance, if there is market news that company X is likely to acquire another highly profitable company Y in the near future, demand for the share of X may suddenly shoot up, spiking up the price.

Pros: High returns in periods of good performance, ownership rights in the company

Cons: High risk, market volatility, no certainty as to returns or even investment

IV.Others

I call this the ‘residual’ category of investment options, which fall outside banks, debt and equity. These comprise more traditional avenues of investment such as:

  • Post office deposits
  • Public Provident Funds
  • Real estate (house property, land)
  • Precious metal (gold, silver etc.)
  • Currency

The first two mentioned above are actually a subset of investment options offered by Statute or tax laws, to enable us to reap tax advantages (remember the dreadful section 80C of the Indian Income Tax Act? No? Good for you!).

As we end

I am sure you’re breathing a sigh of relief by now. It’s all coming to an end. To wrap up, we spoke about broadly three types of investment choices, depending upon one’s risk appetite – Banks, Debt and Equity. Generally speaking, banks provide safe investments with lower returns (low risk, low return), Debt provides low risk and low return (but higher than Banks) and Equity – high risk and high return. In the long run, investments in the Equity markets looks like the best option, from the perspective of high returns. But we don’t know much about share price movements, right? We don’t know which way they may go! We can’t predict which stock will win and which one will lose! But nothing to be disappointed – need necessitates invention and thus we have the safe havens of Mutual Funds.

We will talk about them in greater detail in the subsequent lessons.

Thank you for reading through. I appreciate your patience.

Image taken from Google images.

Finally on my own

The past reminds me of self-abhorrence,
Limitless contempt and hatred for who I was.
That lingering feeling of being so useless,
The burden of guilt without a cause.

I saw the world through others’ eyes,
And rarely had an opinion of my own.
Could never look anyone in the eye,
Stayed indoors just to be alone.

I was so obsessed,
Of people’s perception of me.
Overlooking the self,
Ended up being someone I was never meant to be.

People around me made me feel like a black swan,
When in fact I was the whitest among the lot.
I was told I was lazy,
Ugly, dirty and what not!

I believed others’ assessments of me,
Somewhere I was turning frigid and cold.
Always questioned my own abilities,
But never questioned what was told.

After all the years of suffering and pain,
I was told I am ‘bad’.
My world shattered like glass,
Yet I did not feel sad.

My eyes opened with a ‘pop’ sound,
And things suddenly became clear.
I now understood how gullible i had been.
How irrational with apprehension and fear.

I learnt what I had only read before,
That I am my own best friend.
I live not to tread the laid-down path,
But to set my own trend.

Now I love myself like never before,
And do things that please me best.
I am now the owner of my thoughts,
And everybody else, but a guest.

Life suddenly looks so colourful,
Even when ‘they’ hate me to the core.
Every time I see them with envious eyes,
I love myself even more.

Images taken from Google images.

Lesson #6: Money Begets Money – The Power of Compounding

By any chance, have you ever encountered people talking about the ‘Time Value of Money’ or the power of compounding? Depressing words, aren’t they? Well, let me be honest – my first encounter with the word ‘compounding’ happened in school, when the Maths teacher came beaming in, and started writing something absolutely unintelligible on the black board. That day I realised that ‘compounding’ would never work with me, given that I have always thought of myself as a ‘simple’ person, much more comfortable with ‘simple’ interest. But a rather long brush with Finance gave me both the impetus as well as the passion to not only attempt to understand the once-dreaded concept, but also pass it on to others who may be sailing in the same boat as I did in school.

Let me start rather dramatically – what if I told you about the Law of Attraction (for details, look up Rhonda Byrne’s bestseller The Secret) applies to matters of money too. In lay man’s terms, money attracts money? Or that the more you keep aside now, the more you shall reap in the future? So let me also tell you now that I do not know about the Law of Attraction, but the power of compounding does help in money multiplication. Let me show you how.

Let’s consider a thought experiment: one night you wake up to the sound of a genie who, pleased with you for some reason known only to him, offers you a clay pot. He tells you that at the end of each day, at sharp midnight, he will come to check the contents of the pot, and that he will add to it, the same number of coins as he find in it each night. For instance, it he finds one coin in the pot at the end of the day, he adds one more, making it a total of two coins. At the time of handing you the pot, he also asks you to take good care of it and keep adding coins to it, every time you have extra money or savings.

Now, you wake up the next day and with unprecedented enthusiasm of multiplying your coins, you add a coin to the pot, waiting for the genie to come and view it at night. Here are the results:

End of Day 1: Genie finds one coin and adds another – total 2 coins (1 original, 1 bonus).

Now it is day two, and you realise that the genie has kept his promise, but you have no money to drop into the pot today.

End of Day 2: Genie finds two coins and adds another two – total of 4 coins (2 original, 2 extra).

Assuming that this goes on and on, without any further coins being added from your side, but the genie keeping his promise on a daily basis. Your weekly situation should look something like this:

Number of coins
Day Beginning of day Your contribution Total pot before genie’s contribution Genie’s contribution Total pot at the end of the day
(A) (B) (A) + (B) (C ) (A) + (B) + (C)
1 0 1 1 1 2
2 2 0 2 2 4
3 4 0 4 4 8
4 8 0 8 8 16
5 16 0 16 16 32
6 32 0 32 32 64
7 64 0 64 64 128

What does this table above tell you, let’s think out aloud:

  1. Your total investment (your own money or your own coins) happened only on day 1, the amount being 1 coin. You can see this in column two (B), where after day one, all contributions are zero.
  2. The value of your pot (often called corpus in finance) at the end of just one week is 128 coins. This implies a return of 127% in a week. You know that this means? This means that in a period of one week, your investment (of 1 coin) generated an amount equal to 127 times its original value. This is huge for one week, isn’t it? It is, because this is only an example meant to illustrate how money earns more money. As a matter of principle, always beware of investment schemes that claim to offer such hard-to-believe returns in a short span of time. These are often fraudulent schemes designed to dupe investors.
  3. By the way, how could 1 coin convert itself to 128 coins in a matter of seven days? It could, because of the power of compounding. Think of this – the genie promised to add to the pot, the same number of coins as he would find in it, each day. This happened to be a lose-lose deal for the genie, because he kept multiplying your coins on a daily basis. He found only one coin on day one, so he added one more coin, making it two. The next day, however, he found two coins instead of one, and therefore, add two, to make your corpus equivalent to four coins. On day three, he had to give you four coins and so on. If you look at the last column in the table, you will be able to see that the value of the pot at the end of each day, is simply twice the previous day’s amount. This could happen because everyday the ‘basis’ of reward (the bonus coins from the genie) increased. Everyday day, the bonus got added to the existing base, making it even larger. A larger basis (A + B + C) implying higher bonus and this goes on and on and on.
  4. Takeaway: Even if you are a forgetful investor who has invested an amount and never visited his investment again, you will continue to get richer, with the passage of time. This is owing to the Time Value of Money. Practically this happens because like everything else, the price for money is determined by the demand for and supply of money. Given that on average, the demand for money is higher than its supply in the economy, people are willing to borrow from you, at a certain price. We often receive this price under the name of interest and dividends.

Coming to another point: what do you think the bank does with your money that you have parked in a savings bank account? It simply lends that money to someone else who needs it, earning itself an interest income. It is out of this income that it pays you your 4% on your savings bank account. Simplistically, you lend to the bank, who lends to someone else. Bingo!

Coming back to the present:

Now, what did I want to demonstrate through the example above? Let’s apply it to the natural financial setting, using a simple example of a savings bank account:

Your contribution (B): Represents the amount you have saved and parked in your bank account. This is YOUR saving, your sacrifice of current consumption, towards a better and safer future, an amount you leave aside for using later, rather than today. In our current setup, we usually earn and spend every month. This results in savings also arising on a monthly basis. Just as there are good months and bad, it is not necessary that you manage to save something every month. However, I hope that you are mindful of this example in that not being able to save every month is not as important as letting whatever you have managed to save in the past, REST IN PEACE. As long as you do not withdraw significantly out of it for personal consumption, it will continue to earn for you.

Total pot before genie’s contribution (A+B): This represents the amount or the ‘basis’ on which, the bank provides you interest (or the genie added coins to your pot). Think of this, at the start of each day, if your bank balance is Rs. 10,000, it is also the amount available to the bank to be able to lend to others. If it lends 10,000, it rewards you for 10,000, that you provided to it. However, banks do not reward us as generously as the philanthropic genie. They usually provide us a savings bank rate of about 4% on the (A+B) each day or week or month (as the case may be). Since 4% is constant, we can earn more interest by increasing the basis (A+B). And how do we do that? Simply by putting more money in the bank. Next day, because our (A+B) is larger by the amount of interest credited by the bank to our account, we earn much more interest than the previous day and this goes on and on.

Genie’s contribution (C ): This is the bank interest we receive. If you recall the lesson on ‘Analyse your own income’, you will be able to realise that bank interest constitutes ‘passive income’, given that our money earns this for us, and not we directly. This is what smart people do – they build a massive network of a large number sources of big and small passive incomes, so that in the unfortunate event of their sudden demise or disability, they will continue to live a decent life.

Total pot at the end of the day (D): This is the value of your corpus which usually comprises two basic components – principal (your contribution) and interest thereon. Larger the corpus, the wealthier you are.

Final lessons:

Make your own money work for you, by investing it meaningfully. Of course, given our risk preferences and family circumstances, we can choose from an array of different investment options. Please remember that ‘one size does not fit all’. Also, to be able to earn passive incomes on assets you have created out of your hard-earned income in the past, you must ensure that your money remains in circulation in the economy, for which banks and other financial intermediaries play a crucial role. Unfortunately, most Indians prefer to stash their money either under their pillows or in remote corners of their cupboards. While this may give you an enhanced sense of physical security about your money, you lose what you rightfully deserve – interest income.

I hope that I could present well, what I had intended to. We will look at risk-return trade-offs and investment options in greater detail in subsequent lessons. Good bye and have a nice week!

Image taken from Google images.