Friday, July 10, 2015

Two concepts about money that the school should teach my son...

I love paradoxes.

You know what is the greatest paradox that I find? Our entire educational system is geared towards giving us skills to earn money, without ever teaching us about money.

They don't teach us how to save money, how to invest it or how to make money work for us.

Neither do they teach us about the concept of opportunity cost of idle money nor the relationship between risk and return.

Nothing is taught about how the equity markets function or what is the difference between a stock and a bond.

All of us are working towards earning money for retirement planning. God knows that we are not taught any of that stuff either.

That brings me to the question of the day.

What do I think are the most important concepts everyone should be taught right from childhood?. 

I think there are two financial concepts that everyone should learn.

One is the concept of depreciation.Other is the concept of compounding.

Simple words, big ideas. Simple concepts, big outcomes.

First about depreciation. As everyone knows, depreciation is the reduction in value of an asset due to normal usage of the same. It is the cost of 'wear and tear'. Companies love depreciation. It allows them to reduce their profits and pay less tax to the government. And this can be done without paying a single penny as cash outflow. 

No cash outflow, claim expense, reduce tax. Great, isn't it?

Not so much if you are a salaried employee. As a salaried employee, you cannot claim depreciation on your assets. That doesn't mean that you are immune from the effect of depreciation. That glamorous, sexy Toyota Etios that you purchased off the shelf from the Toyota Dealer? The moment the ownership changed hands, even without you so much as driving it out of the proverbial 'Gate of the Dealer', the car has lost about a fifth of its value. If you pay seven lakh today and want to sell it tomorrow, you will be happy if you can get 6 lakhs for that vehicle. Just the notional change of ownership has reduced the value of the vehicle. That is the pernicious impact of depreciation.

How can you escape this impact? Buy used car. If you wait till January to buy a used car purchased in September of the previous year, you will be able to buy a three months old used car at almost 4/5th of Ex-Show Room Price. You are not losing anything. You are getting an almost brand new car and the previous owner is paying for the depreciation. 

If the previous owner is a business man, he will be happy to conclude this transaction. He can claim both depreciation and the loss as expenses and pay lower tax on his lower profits.

That is smartness. Both from you and the business man...

The awareness about depreciation also teaches us that there are some assets, land being the most extensively quoted, that do not depreciate in value. In fact they do appreciate in value. So is the case with equities purchased at fair value. Their prices tend to appreciate over a period of time.

Purchasing assets that will appreciate in value is called Investing. Buying assets that will depreciate in value is called Expenditure.

So lesson one, if you have money and want to buy assets, make sure to buy those which will appreciate in value. Buy Investment assets. In case you want to buy depreciating assets, make sure that someone else pays for the initial depreciation. 

The second concept is the power of compounding.

They teach us compounding during our school days, of course, they do. Who can forget all those complicated formulae about compound interests and geometric progressions that we were asked to (nay, forced to) learn during those childhood days? We are finally out of it, now that we are adults. Compound interest is for kids, not for salaried employees like us, correct?

Not so fast, mister. Not so fast....

Compounding is the reason why small, innocuous investments done consistently end up as huge values over a long period of time. As you keep on investing small amounts of money regularly, that money is silently, unobtrusively working to create more money for you. 

That is compounding. 

The value explosion has nothing to do with the amount you invest. Value explosion is due to the rate at which money creates new money every day, every hour, every minute, every second.....

That rate at which money explodes is the rate of compounding. Technically it is called CAGR (Compounded Annual Growth Rate).

Power of compounding also means that earlier you start investing (purchasing assets that will appreciate in value), more are the benefits of compounding. 

Power of compounding is what increased the amount of Rs.10000 invested in 1980 to become almost 600 Crores in 2015 (by buying shares in Wipro).

There is another hidden insight to compounding. It is Investment Acceleration. It is like acceleration in a car. 

What does acceleration do in a car? Progressively it reduces the time taken to cover the same distance. Initially you cover 10 Kilometers in about 7 minutes. As you accelerate, you cover 13 Kilometers in the next 7 minutes and 17 Kilometers in the next 7 minutes and so on. As a corollary, an accelerating vehicle will cover same distance in progressively lower time.

(Don't do this on the highway. This is a mathematical illustration).

Compounding is a risk less investment acceleration. Let us say that you buy a share at 50 rupees. If the share price touches 55, you would have got 10% return on your investment. Which means a 10% appreciation in share price leads to 10% of return on investment.

Now assume that the share price has touched Rs. 100. At this price, a 10% appreciation in share price (from 100 to 110) is equivalent to 20% (10/50) return on your original investment. If the share price touches 200, you just need the share price to go up by 2.5% for you to achieve 10% return on your investment.

Can you see the investment accelerating. Same percentage appreciation in price, multiple percentage appreciation in your return on investment. This is compounding.

Do they teach these in schools? No, of course not. Even if they teach us compounding it is to show us in the losing end. An example question on compounding will look like this.

'Mr.Ram borrows Rs.100000 from a bank at an annual interest of 10% with a promise to pay back the principal and accumulated interest at the end of five years. How much will Mr.Ram pay to the bank at the end of five years:
a. If the interest is calculated as simple interest.?
b. If the interest is calculated as compound interest? '

See, in this question Mr.Ram (you and me) is always a borrower who has to pay back principal and interest to the bank. Mr.Ram is never an investor. As per the questions asked in the school, Mr.Ram always is at the receiving end of compounding. He is never the beneficiary of compounding.

Instead of the above question, the school could ask a question like this. Both the questions evaluate the same concept, vis. compounding.

'Mr.Nilekeni purchased 100 shares of Infosys at Rs.100 in the year 1994. By 2014, the number of shares had increased to 1000 and the share was trading at 1000.
a. Calculate the CAGR on Mr.Nilekeni's investment.
b. If in 1994, Mr.Nilekeni had invested Rs.10000 in a Bank deposit at 10% interest rate, compounded for 20 years, what would be the value of Mr.Nilekini's deposit in 2014.
c. Based on the answer to a. and b. above, if you were Mr.Nilekeni in 1994, where would you invest your money? What are the factors that you will consider? 

So there. 'Depreciation' and 'Compounding' are the two topics about money that every individual should learn in school. 

It will help reap 'compounded' rewards.

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