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Session 2: Time Value of Money & When to Start Investing



We are glad to have you with us for our Second Session - Time Value of Money & When to Start Investing

Alright so now let's get started.

The inflation bug as we learnt in our earlier learning session eats into our hard earned savings. So the value of our money reduces. Here in our today's learning session let's learn more about "Time Value of Money", which can help you manage your finances better. Here's an example.

Most of us vie to buy our dream home; so let's take the example of a house that you want to buy.

Have you ever thought...

The dream home...which was worth Rs 50 lac few years ago...costs Rs 1 crore today.

(The above example is hypothetical and for illustrative purposes only.)

Why?

Well, the answer lies in...

Time Value of Money

You see, as inflation, or simply put, the cost of living increases; it erodes the purchasing power of your hard earned money. Let's understand how it works and its impact.

Inflation

Value of all Goods and Services

Purchasing Power of Money

Impact:- Today your Rs 500 note is worth less than what it was a few years ago

To make things simpler, let's take an example here.

Suppose you have won prize money in a contest and you have the option to receive Rs 1 lac today or after 1 year

What will you choose?

Well, rationally...

You will be at an advantage by taking (your prize money of) Rs 1 lac today

Why?

If you choose to take it after 1 year, you may be losing out on the interest that you may earn over the next 1 year...

Rs 1 lac invested today = 1.08 lac after 1 year

[100,000 X 8% = 108,000]
(Rate of interest of 8% is used for illustrative purpose only.)

Now let us see how to calculate time value of money. But before that, first, let us understand some basic concepts.


How to calculate Time Value of Money?

(Some basic concepts)

First, simple interest.

Simple Interest

Well, this is something we have all learnt in our school and college days and sometimes even put it to practice in our daily life. But just to brush-up...

Simple interest is the interest you earn only on your principal amount

Simple Interest: Principal X Rate X Number of Years
100

Let's use an example to understand it better.

What will be the simple interest on a 2 year deposit of Rs 10,000 offering interest @ 10% p.a.?

Simple Interest: 10,000 X 10% = Rs 1,000 p.a.
(Rate of interest of 10% is used for illustration purposes only)

The deposit of Rs 10,000 will yield Rs 1,000 p.a. for the next 2 years

So total interest you earn in 2 years' time is Rs 2,000

The next is compound interest, which again many of us may have heard or learnt about...and it's rather magical in the process of wealth creation. Just to brush-up...


Compound Interest

Compound interest is the interest you earn on both principal and interest

Compound Interest: Amount = Principal X (1+ Rate/100)N

Compounded Interest = Amount - Principal

...Again let's take an example to understand it better.

What will be the compound interest on a 2 year deposit of Rs 10,000 @ 10% p.a.?

Amount: 10,000 (1 + 10%) 2 = Rs 12,100

Compound Interest: Rs 12,100 - Rs 10,000 = Rs 2,100

In 1st year you will earn interest on principal amount of Rs. 10,000 @ 10% i.e. Rs. 1,000

1st Year: 10,000 X 10% = Rs 1,000

In 2nd year you will earn interest on principal amount of Rs. 10,000 + interest you earned in the 1st year of Rs. 1,000; so you will earn interest of Rs. 1,100 on Rs. 11,000 @ 10%.

2nd Year: 11,000 X 10% = Rs 1,100
(Rate of interest of 10% is used for illustration purposes only)

So total interest you earn in 2 years' time is Rs 2,100

Now we can see that compound interest is more than simple interest by Rs 100

Moving a little forward from the basic concepts here are some very vital concepts in time value of money, which can help you on the path to wealth creation.

The first one...


Future Value

Inflation increases the cost of goods, year on year basis. So you may need to pay more in future.

Future Value = Present Value (1 + Inflation)N

Let us understand this with the help of an example...

Say a packet of milk costs Rs 50 today and the inflation rate is 10%. So in this case, what will be the cost of the packet of milk after 1 year?

Well, if we use the formula which we just saw; you have the answer ... and the answer is Rs 55.

Future Value: 50 (1 + 10%) 1 = Rs 55

So you would be effectively paying Rs 5 more for the same packet of milk after a year due to the effect of 10% inflation rate.

(Inflation rate mentioned above is an assumption and for illustration purpose only)

The next important concept is...

Present Value

Real value of money in hand goes on decreasing because of inflation. So in future, your money needs to maintain pace with inflation.

Present Value = Future Value
 (1 + Inflation)N

Let us take this up with the help of an example...

Say, you have Rs 100 in your pocket today, but will the value of Rs 100 be the same 1 year hence assuming inflation rate of 10%?

Using the formula that we learnt in the previous slide - After 1 year Rs 100 note will be worth just Rs. 70.91 - in today's terms - assuming inflation rate of 10%.

Present Value = 100 = Rs 70.91
(1 + 10%)1
(Inflation rate mentioned above is an assumption and for illustration purpose only)

So inflation has clearly eroded the purchasing power of your hard earned money. And to catch-up with this erosion, one needs to invest wisely! While you want to invest wisely, knowing the real rate of return that you are earning on your investments would help you earn effectively.


Real Rate of Return

The Real Rate of Return you earn on your investment reduces due to inflation

Real Rate of Return = Rate of Return on Investment - Inflation

Take this case...

If the Rate of Return on your investment is 15% and inflation is 10%, then what will be your real rate of return?

With the help of the formula...

Real Rate of Return = 15% - 10% = 5%

(The rate of return and inflation rate mentioned above is for illustration purpose only)

So your Real Rate of Return is just 5%.

Many of you may have recognised that the answer to counter inflation is investing. But the question arises: when should you start investing?


When to Start Investing?

  • If you are already saving, then you are just one step away from starting your investment

  • It is never early to start investing, but you can be late

  • You should not wait for the right time to start investing

  • Instead you may gradually start investing

  • Starting early has its benefits!

To understand the benefit of starting early, let's take the famous quote of Mr Albert Einstein, a renowned scientist. He said...

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein


Power of Compounding

  • Earning interest on interest refers to Power of Compounding

  • Longer your time horizon - Higher the effect of Power of Compounding

Now to understand the effect of power of compounding, let's take a case study here...


Longer your time horizon - Higher the effect of

Power of Compounding

The table here indicates - what will be the value of one's saving at the age of 60, if someone would have started saving Rs. 1,000 p.m. at the age of say...

Rs 1,000 p.m. @ 10% p.a. Total Amount Saved (Rs) Value at the Age of 60 (Rs)
Starting Age
25 420,000 3,828,277
30 360,000 2,279,325
35 300,000 1,337,870
40 240,000 765,697
(Source: PersonalFN Research)
Disclaimer: The figures are fictitious and used for example purpose only.
Also, the interest rate mentioned above is for illustration purpose only.

...And what happens when one delays investing?


Impact of Delay

Let's take an example of 2 friends Ram & Shyam.

Particulars Ram Shyam
Starts investing at the age of 25 45
Monthly Savings (Rs) 5,000 15,000
Returns p.a. (Assumed) 12.00% 12.00%
Investment till the age of 55 55
Total Investment (Rs) 1,800,000 1,800,000
Accumulated amount at Age 55 (Rs) 17,649,569 3,485,086
(Source: PersonalFN Research)
Disclaimer: The names and figures mentioned above are fictitious and used for illustration purpose only.


Cost of Delay

To catch up with Ram, Shyam has two choices:
Earn on his investment 36.23%
OR Save per month 75,965
(Source: PersonalFN Research)
Disclaimer: The names mentioned above are fictitious and used for illustration purpose only.

Before we wrap-up this session of learning, here are some points you must keep in mind while managing your finances - to recognise that the key lies in investing...and investing wisely.


Points to Remember.
  • Inflation decreases the value of money over time

  • Prices of goods and services keep on increasing due to inflation (...so you may have to spend more in the future)

  • Money received today is worth more than the same amount of money received after a few years

  • In real terms, inflation also reduces the actual return you earn on your investment (...so do not forget to consider it while investing)

  • Compound interest yields more return than simple interest (...do not forget; the power of compounding is the eight wonder)

  • (And...) Longer your time horizon - Higher will be the effect of Power of Compounding

  • You should not wait for the right time to start investing

  • It is never early to start investing, but you can be late (...So start early and gradually reap the benefits we just learnt)

So to end our today's learning exercise we now invite you to test your learning by taking up this simple quiz (and win exciting prizes!)

Just Click On The Link Below



Thank You For Participating!

Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.


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