There is more to investing than getting high returns!

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Here is a set of slides from the DIY investor meets that hopefully might convince you that there is more to investing than getting high returns. That is, a return above inflation (called a real return) is only one side of the investing coin.

Consider some product or a service or a fee  that costs 10L today.  For an inflation rate as shown below (8%), the cost will increase with time as shown by the blue line.

real1

 

The green line represents the growth of the monthly investment amount at the average annual interest rate as shown above.

After 19 years the value of the investment will overtake the cost. Meaning we would have to wait 19 years to make the purchase.

The real return (approximately) in this scenario is 12% -8%  = 4%

Now, what if the inflation was 10% instead of 8%?

real2

 

When the inflation increases to 10%, it would take 30 years to make the purchase for the same investment.  The return is still above inflation, but that does not help much. The purchase is significantly delayed. Why?

Now consider this,

real3

 

More than double the investment, with less than half the return, a real return of about -2% produces the same result as a real return of +4%: purchase after 19 years.

What if we invest like we would expect a real return of -2% in an instrument that would give us a positive real return?

What if we invest 10200 each month in an instrument that has the potential to deliver double-digit returns?

Unfortunately, many do the opposite. They invest less than the required amount (10,200) in instruments that offer negative real returns.

Loss of capital

Loss does not always mean a negative balance or an actual decrease in value.

real5

 

The result: permanent loss of capital (notice the gap between the curves at 19 years). I use the word permanent because these are the people who are scared of notional short-term losses.  They may never be able to make the purchase.

Not investing enough is an ailment that can affect those who hope to earn a real return too!

real6

 

A real return of +2% means nothing if one does not invest enough.

There is yet another side to this story.   Those who can only invest little (say 1500 pm) cannot take excessive risk in the hope of getting a higher real return. This scenario,

real7

 

can be produced in an excel sheet but is unlikely in real life. At least it is quite uncommon.

What is the point of this post?

When an expense crops up (planned or unplanned) the only thing that matters is the money available us. At the point in time, the return we have got, and how much it is above or below existing inflation rates is irrelevant.

The goal of investing is to obtain a big fat corpus.

The goal is not to beat inflation. The goal is not to obtain a real return.

The goal is to recognise the importance of inflation. Inflation can be overcome  in two ways:

1) investing in aggressive assets. That is in assets with potential to earn a positive real return (return higher than inflation)

2) investing enough capital. This could even be in assets with a guaranteed post-tax return lower than inflation.

You can beat inflation by investing in FD/RD or endowment policies by simply investing enough. See here for an example.

Don’t criticize the product or the agent who sold it to you. Nothing wrong with the product. Most people want guaranteed returns without understanding that the associated price is a huge increase in the necessary investment.

The second suggestion may sound bizarre to you.  I am not suggesting you do that, for that would be an inefficient way to work your money.

I suggest that you combine the two ways:

Invest in an aggressive asset like equity, a sum that you will have to invest in a non-productive asset (like fixed deposits or endowment policies).

That way you can go beyond goal-based investing and create wealth. That is, have a surplus relative to your expenses at any point in life … after a certain age.

There is more to investing than high returns. You need to invest as much as possible and as often as possible. Otherwise high returns won’t amount to much.

Download the visual goal planner (the calculator used to make the above slides)

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About the Author M Pattabiraman author of freefincal.comM. Pattabiraman(PhD) is the author and owner of freefincal.com.  He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006. Pattu” as he is popularly known, has co-authored two print-books, You can be rich too with goal based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management.  He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. Pattu publishes unbiased, promotion-free research, analysis and holistic money management advice. Freefincal serves more than one million readers a year (2.5 million page views) with numbers based analysis on topical issues and has more than a 100 free calculators on different aspects of insurance and investment analysis. He conducts free money management sessions for corporates  and associations(see details below). Previous engagements include World Bank, RBI, BHEL, Asian Paints, TamilNadu Investors Association etc. Contact information: freefincal {at} Gmail {dot} com (sponsored posts or paid collaborations will not be entertained)
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