This is a short post. I am only going to carry forward what I had listed last time to encompass the possibilities of income tax

Last time we spoke on how rupees 10000 deposited at three different interest rates caused such a major change in the outcome after 30 or 40 years

Now let’s look at what can eat into the interest rates that you deposit your money at. Suppose you were to deposit in a account which is giving you 10% interest per annum and which is going to compound the money over the next 30 years

Now see what happens if you have to pay income tax on the interest at 30%. In case of India this is the approximate Income Tax you pay on Bank deposits

Suddenly you see that 10% interest has become 7% (10%-30%*10%) interest,  You do not realise this when you are paying the income tax every year but in a compounding scenario which I showed you in the last post this impacts the same way as if you had had only 7% interest

So what you have to be bothered about is not only the rate of interest that you will get but also what are the Income Tax rules for that rate.  As you saw, even though you deposited with the idea that you would get 10% interest and therefore would end 40 years with 450000 amount of money, the reality is going to be that you will only end up with about a 150000

So while everything has a place ,even a Bank Fixed Deposit has a place in your financial planning you have to be aware that Bank fixed deposits actually earn net of tax a very little amount which may actually be less than the rate of inflation

You cannot be creating wealth if what you are an is less or equal to the rate of inflation

Till next time….

In the last post I showed how the hermit ended up with trillions of kgs of grain. How does that example work for you

Lets consider 3 scenarios where interest rates in a FD (fixed deposit)are 7% and long terms savings bond are 10% and in some kind of equity or land are 15% and I have Rs/$ 10000/- to spare.  One assumption for simplicity is that interest rates do not change in all the above cases over the long term. Second assumption is that income tax has not been accounted for in this.

In 3 years the value of the 10000 in my FD will be Rs/$ 12250, the value of my 10000 in the bond will be Rs/$ 13310 and in the equity it will become Rs/$ 15208/-

In 10 years the same will be Rs/$ – 19671, 25937 & 40455/- respectively – FD has doubled in value while the equity/land has gone up 4 times

In 20 years the same will be Rs/$ – 38696, 67274 & 163665/- respectively – FD has gone up 4 times but bond has gone up 6 times and equity 16 times

& in 40 years the numbers will look like this

Rs/$ 149744, 452592 & 2678635/-

So in 40 years- if I had invested 10000 at the age of 25 and went on to live till the age of 65 – in case of a FD I would made the money grow about 15 times, with just 3% more in case of the bond I would have made my money grow 45 times, but with 8% more I would have made my money grow 267 times!!!

Without putting in any hard labour , my money would work for me and make it grow at different levels as long as I stay invested.

This is something that I learned the hard way, but if you are you at around 25 years off age and chances are that you will live long enough, then investing for the long term even if you have just 10000/- today can make you a millionaire by the time you are 65.

Stay invested …till next time

 

 

When I was a kid I had read a story about how a king had lost his Empire to a hermit. The story was something on the following lines (i don’t remember the exact story)

The hermit defeated the king’s team in some kind of a debate. The king asked the hermit to name what he wanted as his prize. The hermit intern said that the king would not be able to give the prize that he wanted.

This hurt the king’s ego…. so he insisted that the hermit ask for for the gift

The hermit asked the king to bring a chessboard (for those of you who have not seen a chess board it has a total of 64 squares) and said that for each square on the chessboard he will double the number of grains and whatever is the number of grains till the 64th square the king will have to give.

The king thought that this is a very small thing and agreed instantly. So a chess board was brought and the king asked for the grains to be brought. The hermit put one piece of grain on the first square of the chessboard, on the second square 2, on the 3rd he put 4 on the 4th he put 8 and after that 16, 32 and so on.

By the time the hermit had reached the 8 square the number of grains on the 8 square were 256. The king was still ok, however by the time the hermit reached the 16th square the number of grains were 65536. Even now, the king, while he had started getting a little concerned did not bother too much about it and kept asking his people to bring in more grains

By the time the hermit reached the 24th square the number of grains had become 1 crore 67Lakhs (16 million approx) and by the 32nd square the grains had become 429 crores 500 lakhs approximately (in terms of billions this was close to 4 billion grains).

At this stage the king actually started getting worried because now his graneries started getting empty each time the hermit moved 1 square more. By the 64th square the king had to ask all his neighbours for grains

Would you be able to guess what was the number of grains at the 64th box– it was close to 2000 trillion grains. Just for discussion if 1 piece of grain is 1 gram, then the above is 2 trillion kilograms of grain. No wonder the king lost his kingdom, he did not know the power of compounding.

So what does this have to do with compounding – 2 things which I spoke last time –
a. Even if the starting of the grain of your money is only one but you let it grow for a long time then even that 1 Rupee (or 1 dollar or whatever currency you use) can become a very large amount – the hermit had 64 squares of the chess board to grow the number of grains

b. The second is the rate of interest – in this case the hermit had a hundred percent rate of interest so from the first square he started with one grain, went to 2, 4, 8, 16 etc. – when you have a high rate of of interest even a small amount will grow to become huge.

Which brings me back to the equation I had written the last time
S=P*(1+R/100)^N
S= sum of money
P= Principal amount
R=Rate of interest
N=Number of years
So even if you start with a small amount but let it stay for a long time with the right interest rate, you would become rich.

While I read the story as a kid, I learnt the lesson just a few years back(slow learner) ….since then am trying to make others understand, but ….

Till next time….

In grade 7 I learnt Simple Interest and Compound Interest. Unfortunately for me I never understood the implications of compound interest. So while my teacher at that time did give us a lot of problems to solve, I got bogged down with the numbers and getting the answer right.

Being from a family which had come up the hard way in life, they also did not know what magic compounding and tax efficiency can create.

I used to think that the education system of our time was extremly socialistic where talking about money was not considered a very nice attribute. However even now I see young boys and girls coming out of college …. in today’s time and age …. without the basic understanding of compounding….most think that you need to have a high salary to be able to invest or need to have a large amount to make any difference to their life.

And because I meet a lot of very talented people, including finance people and chartered accounts, I see them missing this very fundamental issue of life and hence I am ranting about this so emphatically. My next few posts will only focus on this issue

Which brings me to the equation of compounding I learnt in class 7.
S=P*(1+R/100)^N
S is the sum of money
P is the principal amount of investment
R is the rate of interest and
N is the number of years…(there are some variations to this but we will keep it simple)

The magic is caused because of the exponential power in the equation. So while P may have a small role to play it is the number in the bracket which get multiplied exponentially that creates the magic.

So to all of you who think you need to have large amount of money to be able to invest, please look at this equation again.

Till next time….Carpe Diem