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3 financial concepts you cannot ignore

by Money Puzzle   ·  November 15, 2019   ·  

3 financial concepts you cannot ignore

by Money Puzzle   ·  November 15, 2019   ·  

Photo by samer daboul from Pexels

If math wasn’t your favourite subject in school, you are probably running away from your personal finances too! But just like many other things in life, there is a simple way to do things and there is the hard way around. The simple approach to managing your personal finances does not involve analysing products, making complex calculations or attending technical seminars. What it does involve is knowing three simple calculations and applying them every time you make a decision around investing your money.

Calculations? Does that word give you stress? Here is the thing, you earn money and you work hard for that. Your salary will bring in the stability you need in your earning years and investments will help you grow your wealth for retirement and for any big expenses you may have pencilled in.

If you don’t understand how this money grows, you will not be able to do it justice or use it efficiently.

When you buy a financial product, where does the return come from? What does growth mean? Is there anything lowering this return? These are simple queries and the earlier you learn the answers to these the more efficient you will be in allocating your money.

Now, understanding some of the basic concepts will not take more than 10 minutes of reading time, and there is nothing to lose, then why shy away?

Concept 1

Inflation – You would have heard this word several times, but do you know what it means? Inflation simply means price rise. If you read a statement like, “India’s inflation rose to 4%” – what it means is that – prices in the economy have risen by 4% over prices seen a year ago. If something cost ₹100 last year, it costs roughly ₹104 now.

The real question is prices of what? Does the cost of everything go up 4%? The official consumer price index or CPI inflation in India is not stating the price rise of one product or all products, it’s more like a basket of goods, mostly the essential kind. The items you are likely to find in this basket include fuel, food, clothing, housing and the likes. The price rise for the entire basket is measured as compared to the same time in the previous year. This change is measured in proportion to how much of one item is included in the basket and the aggregate price rise of this basket is then referred to as inflation.

Why should you care about inflation? The basic CPI inflation impacts your purchasing power. For example, if the CPI inflation is at 4%, it means that the prices of goods in that basket are up 4% from last year. This also means that your ₹100 can now no longer buy goods worth ₹100, rather you will be able to buy goods worth ₹96.15 – in other words, the value of money declines because of inflation. If annual inflation remains at 4%, 10 years later the value of your ₹100 will be ₹67.55 because each year prices of goods will increase by 4%.

Common sense dictates that, wherever you invest your money, you should be able to generate a return that is above the average inflation rate. If you are not doing that, you are really not growing your wealth, inflation is eating into it every year.

This is just one aspect. Inflation or price rise in services like education and medical care has historically been at least 8%-10% annually. So, if you are planning to invest towards your child’s education you have to ensure that you not only beat standard inflation but rather in the long run you have to earn more than the price rise in education.

Only when you understand how inflation reduces the value of your money every year, will you understand that your choice of investments needs to beat inflation in the long run.

Concept 2

Compounding – This is technically a jargon but practically worth all your time. To compound means to add. Compounding is a process of earning a return on your return. Let’s say you invest ₹100 and get a return of 10% or ₹10. If you let the ₹10 be as it is and keep it along with the ₹100 rather than taking it away, you can now potentially earn a return on ₹110. Now, 10% of ₹110 is ₹11. You are already earning more, without any additional investment. This is the power of compounding.

If you want your investment to earn a return that will beat inflation consistently over longer periods, you have to rely on compounding returns. This is possible only if you invest with a long-term horizon as compounding returns take time. This always means that the earlier you start investing the more time you are giving your investment returns to compound.

Let’s go back to the 10% per annum assumption, in 10 years your ₹100 investment will be worth ₹259. Give it 10 more years and the return more than doubles to ₹672.

This is not a complicated calculation – you just have to multiply your original investment, let’s say, Rs 100 with the expected return raised to the number of years OR 100*(1.1)^10 – this equation assumes a return of 10% for 10 years, the 10% is represented as 1.1 or capital plus return.

If you understand this concept you have the magic of long-term investment all figured out.

Concept 3

Taxation – Once you know what your money is worth post inflation and investment returns, don’t forget the taxman. Although it’s not efficient to make investment decisions solely based on the tax, there is merit in always comparing post-tax returns.

This is important because we rarely compare like with like when it comes to investment returns. When you look at fixed deposits and compare them with mutual fund returns, you have to know that the tax treatment is different and hence, its post-tax returns which matter most and not the nominal return you make.

Basic tax rules and calculations:

  1. For any investment which gives you a fixed interest, you will be taxed on the interest portion at the income tax rate applicable to you. If you pay income tax at 10% then that is what you will pay on the interest received. Paying tax on the interest means the final amount due to you will be reduced by tax due either at source or later when you file your tax returns. This applies on fixed deposits and bond, debentures and small savings schemes.
  2. For debt mutual funds, if you receive dividends, you will end up paying around 28.5% dividend tax. The amount of dividend you receive in your account will have already been reduced to account for this tax.
  3. For debt mutual funds if you incur any capital gains or gains from change in price of the fund, you will have to pay short term capital gains tax if the gains have been made before 3 years holding period and long-term capital gains tax if it is after 3 years. Short term capital gains tax works similar to tax on interest payment i.e. as per your income tax rate. Long term capital gains tax is calculated at 20% after adjusting the original cost of investment for its inflated value. This adjustment tends to increase the original cost and hence, reduce the capital gains figure used for tax calculations. Higher the annual inflation lower will be your final tax paid and vice versa.
  4. For equity mutual funds, tax on dividend is at 10% and again this is deducted before you are paid the dividend. Capital gains tax for equity funds is applicable at 15% for short term gains or gains made on funds held for less than a year and at 10% for long term gains (holding of more than a year). The same taxation applies to individual equity stocks.

Taxation sounds like a lot to digest, but it is important to understand your final return. Remember investments are your alternate income, hence, if you are particular about the tax paid on your salary – this should matter too.

While it is true that you must engage an advisor if you don’t understand the nuances of financial planning, but even with an advisor you must understand the basic calculations else you are going in blind. The consequences of this won’t matter till there is a shortfall at which point it will be too late to redress the wrong choices.

Take ownership for YOUR money and make it work hard YOU, but don’t deny yourself the common sense needed to get the best outcome. Start investing early, but also, START SMART.


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