What decides an individual’s financial preparedness for the future? You will get a variety of responses. A closer introspection would reveal that while the income or salary is an important starting factor, it is the investment – where, how much and how long – that eventually decides what we end up with. Income per se does not give the solution, but what we do with the income, matters more. Here we will see few scenarios on the way individuals invest and their outcomes.
Investment— “WHERE” matters
There are multiple asset classes for investment available for Indians to choose from. There are traditional fixed income options like fixed deposits (FD), Public Provident Fund (PPF0, gold and some evolving market linked ones like equities, mutual funds, etc. As mentioned above, while income is an important factor, where and how we invest the savings decide, how well we are prepared for the future. Let us take an example of two individuals with similar saving propensity to understand this better.
- Anjali had a salary of Rs.20000 per month (2.4 lakh per annum) and Bindu had a salary of Rs.30000 per month (3.6 lakh per annum) in the year 1998. Both were getting 5% increment every year.
- Salary in 2017: Anjali – Rs.50,540 per month (6.06 lakh per annum) and Bindu – Rs.75,810 per month (9.09 lakh per annum).
- Both save 40% of their salary, say at the end of every year (earnings of 1998 is invested at the end of 1998 and so on), for 20 years (1998 to 2018).
- Anjali follows an asset allocation of 75% into equities and 25% in FD (now, for simplicity) and Bindu invests entire savings in FD
- Going by the real time data, their investments as of Dec-2018 would be around:
- Anjali (Asset Allocation) – Invested: Rs.31.74 lakh ; value in 2018 would be Rs.1.23 crore at CAGR: 13.2%
- Bindu (Only Fixed Income) – Invested: Rs. 47.61 lakh ; value in 2018 would be Rs.99.50 Lakhs ; CAGR: 7.6%
What we noticed:
Bindu earns 50% more income and invests 50% more, than Anjali throughout. Both increased their yearly investment, commensurate with growth in their income. But in terms of value of the investments, Anjali ended up making Rs.23.5 lakhs or 23.62% more than Bindu, primarily because of the choice of asset class for long-term investing. Varied allocation mix could produce different results. In which asset class one is investing his/her income is much more important than what the income is. Post taxation, FD returns would drop further.
Investment – “HOW MUCH” matters:
Taking a different perspective, the degree of savings makes a difference in the future value of investments. Let’s look at how the future value grows for two individuals earning the same salary, but save differently.
- Arun and Sajan had a salary of Rs.30000 per month (3.6 lakh per annum) in 1998. Both get 5% increment every year
- Salary in 2017: Rs.75,810 per month (9.09 lakh per annum) for both
- Arun saves 25% of the salary and Sajan saves 40% of the salary
- Both follow asset allocation of 75% in equities and 25% in FD
- Their investments as of December-2018 would be around:
- Arun – Invested: Rs.29.76 lakh; Value: Rs.1.15 crore; CAGR: 13.18%
- Sajan – Invested: Rs.47.61 lakh; Value: Rs.1.84 crore; CAGR: 13.18%
What we noticed:
Both earned the same salary and had similar increment. Arun saved 15% gross or 38% effectively less than Sajan. Eventually Sajan ended up making Rs.69 lakhs or 60% more than Arun. Essentially this is the power of inclination to save. The more you save and invest, the more you will benefit in the long-term. This is the outcome even when both adopted the same asset allocation (with equities).
In another view, see how the future value grows for two individuals earning the same salary, in this scenario:
- Chithra and Dhanya had a salary of Rs.30000 per month (3.6 lakh per annum) in 1998. Both get 5% increment every year.
- Salary in 2017: Rs.75,810 per month (9.09 lakh per annum) for both
- C saves 40% of the salary every year and D started with 40% of the salary in first year and did not increase it there after.
- Both follow asset allocation of 75% in equities and 25% if FD
- Their investments as of December-2018 would be around:
- Chithra – Invested: Rs.47.61 lakh; Value: Rs.1.84 crore; CAGR: 13.18%
- Dhanya – Invested: Rs.28.80 lakh; Value: Rs.1.38 crore; CAGR: 13.36%
What we noticed:
Chithra and Dhanya both started off by saving 40% of their income. Chithra kept it intact over years, meaning the amount of savings was in line with rising income. But Dhanya did not increase the savings commensurate to her income growth. What started off as 40% savings of the salary in the first year ended up with 16% (Rs.12000/Rs.75810) of salary in the 20th year. Most of the existing equity investors fall in this zone. While on one side the existing portfolio grows well over the years, the opportunity to grow higher commensurate to the potential is missed. Dhanya ended up Rs.46 lakhs lesser than her potential, given the same asset class performance.
Investment – “HOW LONG” matters:
In the world of investments, duration is a very important factor. Let’s understand this with the help of two individuals saving for different durations at a common rate of return.
- Raj and Dileep save Rs.100000 each and increases it by 5% every year. Expected rate of return: 12% per annum
- Dileep started in 1998 and invested for 20 years and Raj started 5 years late and invested for 15 years
- The value of their investments in December-2018 would be:
- Raj – Invested: Rs.21.58 lakh; Value: Rs.54.31 lakh; CAGR: 12%
- Dileep – Invested: Rs.33.06 lakh; Value: Rs.1.12 crore; CAGR: 12%
What we noticed:
Both Raj and Dileep were investing the same amount of money and increasing it as well. But a delay of just five year cost Raj Rs.57.69 lakh or more than what was saved in 15 years. This is because of the ‘Power of compounding”. The power of compounding multiplies with time. Longer the duration of the investment, higher would be the potential wealth.
Key Takeaways:
- Follow asset allocation. This is the starting point for a better overall investing experience. Study and analyze the risk taking ability, duration of various goals and choose the asset class. Be Risk Aware, but not Risk Averse. Empirical data suggests that equity as an asset class has the ability to out-perform other asset classes in the long-term, but is prone to volatility in short term. Higher allocation to equity in the early working years is advisable. One can reduce the equity component and move more to fixed income as one nears retirement.
- Systematic Investing Plans (SIP) help navigate the volatile market with the cost averaging principle. Don’t stop your SIP, when market comes down.
- Invest adequately. Don’t start investing with some random small amount and get into an illusion that this will be enough to take care of everything in life. Revisit your spending patterns and try to cut expenses where ever possible and increase your investment propensity.
- Keep a watch on the growth in your income. Ask yourself this question, ‘When was the last time you increased your SIP / investments’? Your savings rate and eventually the investment rate should keep pace with the income, so that you don’t miss out on the potential to grow your wealth.
- Start early. Never delay investments, especially if it involves compounding effect. Time itself is money and unintended delay will reduce the long-term wealth.
In the words of the legendary investor Warren Buffet, “Don’t be proud of your salary. Be proud of your investment”.
(In the above mentioned scenarios unless specified, equities represented by Sensex TRI December averages; fixed deposits: average 1-3 year rates.)