(Author is an alumni of NITK,Surathkal and is presently pursuing Management studies at IIM, Bangalore. He was previously employed with Microsoft and Intel, and he also owns a ALOHA-Abacus franchise at Kulshekar, Mangalore. All views expressed here are his personal. He can be reached at )
Understanding Personal Finance: Part-2
In we have seen how one can benefit by starting investments early in life. Here in Part-2 let us try to see another concept, Present Value of future returns.
Present Value of Future Returns
Understanding present value is very important in any investment. Most of the times we would be assuming the maturity amount or the final sum we would be getting are sufficient for our future needs. But the crucial mistake majority of us do is that we calculate the price of products or services using its present cost and we do not count the inflation part.
Let’s look at the concept in detail. A sum of Rs1 lakh in hand worth much more than Rs1 lakh received after few years. To buy the same products and services one would need much more money because of continuous increase in prices and increase in cost of living (Inflation). If you look at it in reverse order, a future sum of Rs1 lakh is equivalent to a much lesser amount today. It’s the same logic.
Above table and chart has the present value numbers of Rs1 lakh (future sum) considering an inflation rate of 5%. One can notice that a future sum of Rs1 lakh received after 30 years has present value of Rs 23,138 only. Not even one fourth the amount!!. This is what inflation can do. Higher the inflation, higher is the value erosion of your money.
Let?s take simple cases of long term investments and understand why one has to get this present value concept before investing.
Returns from Child Education Plan
Sanjay, a software engineer, in his late twenties had recently got a 10% hike in his pay. He wanted to utilize this additional amount in building a corpus for his child?s professional education purposes. He was not sure how much to invest every month so that it will be sufficient to cover this expense for his child 18 years later. He started investing Rs 5,000/- , that he got from pay hike, in the child education plan without finding the right maturity amount.
He knew if he had to send his child today for medical college he would need minimum of 12lakhs to cover 4-5 years of fees and expenses. Last year one of his cousins had joined a top medical college and had to pay around 3lakhs as the management capitation fee leave aside other fee and expenditures. Considering his case, Sanjay calculated other expenses and figured out Rs12lakhs as the least amount one would need considering cost of living today.
He thought this cost would be at least double in 18years and did not care much to calculate. His child education policy had maturity amount of Rs 24lakhs and he was happy about the whole thing.
As you can see in the above chart, Present Value of Rs1 lakh received after 20 years is just Rs 37,689/- and using the same calculations, what would be the inflation adjusted amount after 18 years that is equivalent to Rs12 lakhs today? It?s close to Rs 29 lakhs.
Would Sanjay be able to fulfill his dreams? If he invests in an instrument returning 8% year on year, his monthly investment of Rs 5,000/- for continuous 18years can fetch him a total sum of Rs 24 lakhs only and that?s what he was getting as the maturity amount. If you calculate its present value of his maturity amount, it is just Rs10 lakhs! It?s definitely not enough.
In order to make up for the difference of 5lakhs in maturity amount, Sanjay, can either increase his monthly investment to Rs 6,000/- or he can choose a better plan which gives higher rate of return.
Returns from retirement plan
Let us take the case of retirement plan. What would be a right retrial amount or pension amount for Sanjay, say after 30 years from now? How much should he invest now so that he would not feel short of his monthly expenses after retirement?
If he can imagine himself to be of age 58 today, then it becomes simple to find out the monthly expenses considering the present cost of living. If he feels that a income of Rs 20,000/- monthly is sufficient today to cover his family expenses, then using the power of compounding at a constant rate of inflation of 5%, the future value of the same comes to Rs 86,438/- (after 30 years).
Assuming, Postal Monthly Income scheme still exists after 30 years with same 8% returns, Sanjay can deposit his maturity amount created after 30years in this scheme to generate a monthly income. Simple question here is what should be the right maturity amount? In this case, it comes to Rs1.3 crores. It looks huge, but not really.
A monthly investment of Rs 9000/- for continuous 30years with constant 8% rate of return would get us there or if we choose an investment instrument giving us 12% interest year on year, just Rs 3750/- per month would be sufficient.
Increasing your options
I have taken these two cases as examples and I think most of us have either invested or will be investing in similar plans. If you have got these two scenarios properly in your mind and if you have understood how to evaluate using present value concept, the rest is simple, choosing the right investment opportunity or the right investment amount. Evaluating this way not only you are increasing your options but also you can a make wise investment decisions which can work better for you in the long run. Unfortunately many (but not all) investment/insurance agents sell their products without understanding customer needs and go just by their commission. The next time your agent comes to sell, may be you can evaluate it yourself!!!
Moving on from present value concept, in the next part I will try to put in my thoughts on leveraging loans to increase our investment returns. A common trick people use in real estate investments!!!
Author: Pramod DSouza- Bangalore