Wednesday, August 19, 2009

Part 5: All about returns - time for some math

Pay Yourself first. Open a Third Bank Account. Make it investment ready. Have a spending target. Put the balance into the TBA.

Understand that there are different kinds of risk – Physical risk, Risk of default a.k.a. Credit Risk, Risk due to inherent volatility, and Interest Rate Risk.  Evaluate assets on the criteria of Risk, Return and Liquidity.  In general, higher risk needs to be compensated by higher return.  Now that we have done some revision, we can move ahead!

Talking about return, it is measured in terms of percent per annum.  What would Rs. 10,000 in an 8% fixed deposit amount to, in five years?  Dredging our memories will yield the compound interest formulae last used in Class Six:

Amount = Principal x  (1 + Rate/100) ^ Period

Hence in this case, (10,000) x (1.08)^5 = Rs. 14,693, i.e. 1.47 times your Principal. 

8% for ten years works out to 2.16 times; twenty years to 4.66 times; thirty years to 10.6 times; forty years to 21.72 times; fifty years to 46.9 times; sixty years to 101.2 times;   Notice that as the time period increases, the rate of increase increases too!

Over a thirty year time period: 8% yields 10.06 times; 10%, 17.45 times; 12%, 30 times; 14%, 51 times; and 16%, 86 times.  Notice that over a long time period, an arithmetical increase in interest rate results in an exponential increase in return!

Moral of the story?  Every one percent increase in interest rate matters over the long term.  And the longer the time period, the more the beneficial effects of compounding.

Compound interest is the eighth wonder of the world! To use this principle to your advantage, you need to resist the itchy-fingers syndrome – once your money is invested somewhere, don’t give in to the temptation of booking profits in a hurry – be in it for the long term!

Continuing with the above example, if your Rs.10,000 is invested at 8% for 30 years it grows to Rs. 100,626.  If inflation in the meanwhile was running at 6%, what is your Rs. 100,626 thirty years hence worth in today’s terms?  That would obviously be:

100,626 / (1.06)^30 = 17,520 in today’s terms.  You can imagine what will happen if you keep your money lying around without earning interest.

Your grandfather bought a piece of land 50 years back at Rs.50,000.  It is worth 1.25 crores today.  You don’t have access to Excel – how would you calculate the approximate rate of return using only an ordinary calculator?  The money has grown 250 times.  2 raised to 8 is close to 250 (256).  Hence the money has doubled 8 times – 50/8 gives one doubling per 6.25 years.  If your money doubles in 6.25 years, what is the rate of interest?  It’s not 100 / 6.25 since it is compound interest we are talking about.  When you are dealing with compound interest you should use the “rule of 72” – calculate 72 / 6.25.  That gives 11.52 percent.  The actual rate works out 11.68 percent which is close enough. Remember the “rule of 72”.  It’s useful.

In the financial world 1% is sometimes referred to as 100 basis points.  So, an increase of 25 basis points means a 0.25% increase.

How does one measure Risk?  Let us say you are evaluating which mutual fund is better among a range of options.  They are all similar Equity Funds and all of them measure their performance against the BSE Index.  You first list down the “returns” that each of them has generated, say, in the last five years, along with the return on the BSE Index for comparison.  The absolute return is one measure and it’s a good one; but how do you account for the fact that some funds may be following a more risky investment strategy, i.e. their returns may be more volatile in comparison to other funds? Here you need some measure of measuring “risk” which in this case means the risk inherent in variability of returns.  There are several specific formulae to measure this (which we shall see much later in this series) but in general the principle followed is the same.  In order to measure risk, what is measured is the range and amount of deviation of the yearly (or any period’s) return from the average/mean return for each particular fund.  The resultant number, whichever formula is used, indicates the “risk” in the investment strategy followed by fund.

Coming back to the subject of “return” - you must use the principles explained above to discount any future returns to today’s terms in order to compare two different options.  Let me illustrate this with an example.  You invest Rs. one lakh upfront in Bond A which gives you a cash flow as follows:

Year 1: 25,000
Year 2: 45,000
Year 3: 50,000

There is another Bond, Bond B, where the returns on your one lakh are as follows:

Year 1: Nil
Year 2: 30,000
Year 3: 95,000

Which is the better bond to invest in? Assume that they are both equivalent on the risk scale.

Bond A gives Rs.120,000 over three years.  Bond B gives 125,000 over three years.  Bond B is better.  Hey, wait a minute!  What about time value of money?  If another Bond C yields two lakhs but after twenty years, would that make Bond C better?  We need to discount all the above cash flows to today’s terms. Let’s do that.

We have to first decide what interest rate to use for discounting.  Let’s use the long term average inflation rate, say, 7%.  The Net Present Values of the cash inflows on Bond A will be: (25,000 / (1.07)) + (45,000 / (1.07)^2) + (50,000 x (1.07)^3) = 103,484.

Bond B works out to: (0 / (1.07)) + (30,000 / (1.07)^2) + (95,000 / (1.07)^3) = 103,752

Bond B is better when you discount the cash flows to the present, but only marginally so.

What happens if we use 12% for the discounting?  Net Present Value (NPV) of Bond A works out to 93,784 and of Bond B works out to 91,535.  Bond A looks better! A change in the discounting factor could impact these calculations!  In this case, Bond B’s cashflows are backended and an increase in the discounting rate tends to decrease the values of cash flows which are farther in the future. Intuitively, you can understand why it is so. If inflation is higher, for example, your appetite for accepting the same promised return in future would be considerably diminished. Decision on which discounting factor to apply is critical in such situations – we may revisit this at a later point in time.

That’s a lot of math!  It is very important to understand how compounding works, and the impact of time on the value of money.  Hence the diversion in this issue.  A revision course in sixth and seventh standard math will help!

Bye.  Till we meet next.

Dinesh Gopalan
Fidelity India Finance
mobile: 9845257313

Wednesday, August 5, 2009

Part 4: There is no life without risk

From the moment you are born till the day you die, life is an unending stream of unpredictable events.  The financial sector is no different.  It throws various options at you ranging from your brother-in-law asking for a loan to the most complex financial derivative products which even the originators don’t understand.  In order to make financial decisions easier, and to be able to expose the bluff behind many tall and confusing claims, it is essential to know how to evaluate these options.  For this you need to know what are the different kinds of risks and their evaluation; evaluation of cash flows which vary in timing; concepts of present and future value, and a few other sundry stuff like that.

If this sounds like the beginning of complicated financial theory, don’t worry.  Except where absolutely necessary, in this column we shall stay out of complicated equations and needless computations.  Some amount of math is required especially relating to compound interest (as we shall see in the next issue) but not much more than that.

Understanding of Risk is fundamental to analyzing financial instruments. In the last issue we looked at “default” risk (which is also called Credit Risk) and “volatility / variability of return” risk.  Another fundamental risk is of course “physical” risk – the risk that someone will put a knife to your throat and force you to empty your safe.  Or encroach on your land. Watch Khosla Ka Ghosla to know what I mean.

What about ‘systemic’ risk?  When Kuwait was invaded by Iraq, Kuwaiti currency became worthless overnight.  The bank accounts of all Kuwaitis were inoperable; as to stock markets, even if they had existed, they would of course be shut.  In such a situation, especially when you are fleeing across the border, probably the thing that would help you the most is Gold.  Real assets like Gold and Real estate are just that – “Real” – they are held by you and are very tangible. Of course you could get mugged, or your land could be encroached upon. 

There is another kind of risk called ‘interest rate risk’.  Let’s assume you lend someone one lakh rupees and he gives you a ten-year ten-percent bond (that means he will pay you ten thousand rupees a year for the next ten years and then repay your principal – if he is still alive).  If you sell this bond to your friend after two years you expect him to give you one lakh rupees for it.  He will, provided the interest rates in the market are ruling at 10% then.  What if the new ten-year bonds in the market yield an interest of 12.5%, i.e., give an interest of rupees twelve thousand five hundred every year on one lakh of investment? He would then obviously pay you Rupees Eighty thousand for your bond – such that the rupees ten thousand interest on it works out to a yield of 12.5%. 

Thus, if interest rates go up, prices of existing bonds in the market go down; if interest rates go down, bond prices go up.  Interest Rate Risk is a fundamental principle in Finance – work out a few examples yourself so that you understand this concept well. 

Different assets have different kinds of risk profiles.  Risk is one way of evaluating an asset.  Another thing you have to be conscious of while considering an asset for investment is Liquidity.  Liquidity means nothing but how fast you can convert something to cash.  By definition, cash is the most liquid of all assets.  Bank Fixed Deposits are highly liquid since you expect to get your money out immediately subject to certain formalities.  Stocks are highly liquid.  Remember we are not talking of how much money you are taking out on selling compared to your investment, but how quickly you can take it out.  The settlement cycles on the Indian Stock Markets are highly compressed nowadays – you can get your money out in three working days.  Land is highly illiquid.  It takes a long time to sell.  Gold in any form is always highly liquid.

There are three pillars of Asset evaluation.  The first is Risk.  The second is Return.  The third is Liquidity.  Any investment that you consider must be evaluated on these three parameters.  You first need some benchmarks to start with.  Let us assume that in our case, the benchmark is the one-year FD rate of SBI which is, say, 7%.  Would you invest in Lord Yama Co-operative Bank (this is promoted by a bunch of people with shady antecendents) for a return of 9%?  You may, since the return is higher; but you need to assess whether the two percent is enough compensation for the additional risk compared to SBI.  Would you invest in Koffman Finance (promoted by an unknown group of people) at 20% per annum in a bond that is non-redeemable for five years?  In this case, the return is great but the risk is too high.  I would not.  Would you invest some money that you have kept aside for your daughter’s wedding (she is 25 now) on a plot of land?  I would not, since land is not liquid and is more of a long-term investment, and I would be hoping that my daughter at 25 would be getting married soon.  Would you invest your retirement savings fully in fixed deposits or other debt instruments (You are 25).  The returns on debt are known, they are steady, and they don’t cause sleepless nights.  For a 25-year old who is saving for retirement, the capacity to take risk should be higher than that.  You should be aiming for equity or real estate investments where the higher risk is largely mitigated in this case by the longer time period involved; but the expected returns are higher.  If I were you, in this situation, I would invest my money predominantly in a mix of equity and real estate.  Would you invest your retirement proceeds in equity (you have just retired at 60)?  That goes against the tenets of financial planning.  At the age of 60, your appetite for risk is supposed to be lower.

The more you understand and internalize the concept of Risk, the better it is. An understanding of Risk is fundamental to any financial decision.  Your own capacity to take risk is dependent on several factors including your age, current financial status, status of current investments, status and state of equanimity of spouse, your own financial goals, the certainty of holding on to your current job, etc.  Above all, your capacity to take risk is determined by your own personality. 

That was all about Risk. In the next issue, we shall look at Time Value of Money and its practical applications.  As you can see, it’s not that simple – we do need to understand some concepts and tools before getting into discussions on where to invest, etc.;  however, it’s not so difficult either! 

This is the fourth part of the series – I hope you have read the first three (available in ‘Archives’ in case you have not). Please feel free to write in your feedback now as well as at any point in time in future, along with any suggestions that you may have.  I hope you have enjoyed reading thus far.

Do write in.  Bye – till the next issue.