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The fine art of investment

Source : SIFY
Last Updated: Fri, May 22, 2009 14:34 hrs

We have a friend who stayed away from the market a couple of years back since it was too high. And then he stayed away since it was too low. And now he is staying away since it has run up too fast too soon.

So basically, for more than two years he has kept his funds idle waiting for the ideal opportunity to enter. However, such ideal opportunities are only evident on hindsight. Five years from now, we would all look back and say that on such and such day the stock market indeed hit its bottom and then the recovery began.

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However, hindsight is not helpful to invest in the present. While our friend still waits for his "ideal opportunity", the market has gone up to 13887 points from a low of 8198 points on March 5, 2009.

 Ideally, one should never look at short-term returns from the equity market. Over the long-term, the compounding effect kicks in. Albert Einstein called compounding the eighth wonder of the world. In the book, "Once Upon a Wall Street", Peter Lynch, one of the most successful mutual fund managers the Wall Street has ever seen, narrates a story.

Consider the Indians of Manhattan, who in 1625 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 362 years the Indians have been the subjects of cruel jokes because of it - but it turns out that they may have made a better deal than the buyers who got the island. At 8% interest on $24 (Note: Let's suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion.

Tax incidence on company accommodation

Give Manhattan the benefit of doubt: That $28.1 billion is the assessed value, and for all anybody knows, it may be worth twice that on the open market. So Manhattan's worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change.

This little story shows you the power of compounding and the points out the fact that the earlier you start investing the better it gets.

Illustration

Let's try and understand this through an example of two friends Ravi and Kirti. Both start working at the same time at the age of 23. Ravi starts saving when he turns 25 and invests Rs 50,000 every year. Assuming that he earns a return of 10% every year, at the end of ten years, Ravi is able to accumulate Rs 8.77 lakh. After this, due to financial constraints, he is not able to invest any more money. But at the same time, he does not touch the capital that he has already accumulated, hoping to live of it when he retires.

Therefore, he lets the Rs 8.77 lakh grow and assuming that it continues to earn a return of 10% every year, he would have been able to accumulate around Rs 95 lakh by the time he turns 60. So the Rs 5 lakh (Rs 50,000 x 10 years) he had invested in the first ten years has grown to Rs 95 lakh. This even though he stopped investing Rs 50,000 every year after the first ten years.

Jeevan Aastha: Glorified fixed deposit plan

Now let's take the case of Kirti. During the first few years of his employment, Kirti enjoyed life and spending money on all kinds of things rather than invest regularly. At the age of 35 reality suddenly dawns on him and he starts investing Rs 50,000 every year. He invests this amount every year till he turns 60, i.e. for twenty-five years. Assuming he also earns a return of 10% per year on his investments, at the end, Kirti would have managed to accumulate just Rs 54.1 lakh.

Even after investing Rs 50,000 regularly for twenty-five years, Kirti has managed to accumulate only Rs 54.1 lakh, which is around Rs 41 lakh less in comparison to Ravi. Now Ravi has invested only Rs 5 lakh over the ten years he invested. In comparison, Kirti over the twenty-five years has invested Rs 12.5 lakh (Rs 50,000 x 25 years). Even by investing two and half times more than Ravi, Kirti has managed to build a corpus, which is 43% less. This happened because Ravi started investing earlier. This allowed the money to compound for a greater period of time.

Overcoming financial phobia

Also, as the corpus grows, the impact of compounding is greater. Ravi, as we know, had managed to accumulate Rs 8.77 lakh after ten years and then he stopped investing Rs 50,000 every year, allowing the accumulated corpus to compound for twenty years more.

Let's say, he had allowed the corpus to compound for only 20 years more till he turned 55. If the corpus had earned a return of 10% every year, then at the end Ravi would have accumulated a corpus of around Rs 59 lakh. By choosing to let his investment run for five years more, Ravi managed to accumulate Rs 45 lakh more.

Clubbing provisions under income tax

Real Life Illustration

To give a practical example, let's take the case of HDFC Top 200 Fund. The five-year return of this fund is still 24.8% p.a. - even after the market meltdown and global recession. What this means is that had an investor invested say Rs 50,000 five years back, the investment would have grown to around Rs 1.51 lakh.

To be a successful investor, all you need is the correct investment vehicle and loads of patience and conviction. In other words, to succeed in the market is entirely up to you, the question is are you up to it?

The authors may be contacted at wonderlandconsultants@yahoo.com



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