Case Study – When investing for 10 years pays more than investing for 30 years

I started earning when I was 23. Pretty late I guess. Nevertheless, not everything is under our control.
 
But benefits of starting early cannot be matched easily by other reasonable approaches (like even investing more in later years). And I did some calculations that once again prove that as far as saving and investing are concerned, best advice is to START EARLY.

Next piece of advice? Don’t doubt the two words of the advice above. 🙂

Invest 10 vs 30 years
The calculations that follow are based on certain assumptions, which you might question. I have tried to address the concerns later in the post. But I suggest that you focus on the crux of the story here, which is – to start investing early.

Scenario 1:

Suppose a person who starts earning at 23, is able to save Rs 1.5 lacs every year for next 10 years. He then stops (at 33) and doesn’t invest anything till his retirement.
 
What will his corpus be at the age of 60 (i.e. retirement)?
 
I will bypass the discussion on expected returns and how resorting to better asset allocation strategy can increase expected returns. Instead, lets use a reasonable and constant return assumption of 8% per annum.
 
Calculations show that at 60, his corpus would be about Rs 2.02 crores.
 
Now remember that this person has contributed a total of Rs 15 lacs from age 23 to 32. And not a rupee more after that.
 
Scenario 2:

Lets take the case of another person who realizes the power of compounding a little late and starts at 31. He continues investing Rs 1.5 lac every year till his retirement.

In total, this person would have contributed Rs 45 lacs in 30 years.

And he will end up with a corpus of Rs 1.83 crores.

See the difference?
 
First person invests Rs 15 lacs in 10 years and gets Rs 2.02 crore.
 
Second person invests Rs 45 lacs in 30 years and gets Rs 1.83 crore.
 
Now we all know that its not possible to invest a very large amount at the start of our careers. The annual investments gradually increase with increase in income. And in reality, investments neither stop at 32 (like first scenario) nor they remain constant between ages 30 to 60 (like second scenario).
 
So this is indeed a theoretical exercise. But it serves the purpose of highlighting the importance of starting early.

Scenario 3:

Now lets take another scenario:
 
Suppose your parents decide to invest Rs 1.5 lacs for 2 years after you were born. Then from the age 2 to 60, neither you nor your parents contribute anything. Unreasonable assumption but lets stick to it.
 
Result?
 
Corpus of Rs 3.15 crore at the age of 60.
 
The reason for this astonishing outcome is that Rs 3 lac invested immediately after your birth had many decades to compound.

And by the time you turned 23 and were ready to earn your first rupee, your corpus was already in excess of Rs 18 lacs. That’s a good amount to start with. Isn’t it? A big snowball to start rolling for someone who is yet to earn anything. 🙂

Again the assumption of Rs 3 lacs can be questioned. An amount of Rs 3 lacs was huge 23 years ago. But again, this is a theoretical exercise. It only proves that starting early works. It just does.
 
Investing 10 years
 
But don’t get disheartened if you are unable to invest in line with either of the first two scenarios or if your parents did not do anything like the third one. 😉

When it comes to compounding, there is no amount too small to start investing.

And remember that in initial years, you will not notice the impact of compounding. Its only after years that compounding starts to show its magic.

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How to manage your finances when you get your first job?

Congratulations!! I just came to know that you got your first job. That too a well paying one. And that too at a young age of 21. There is no feeling which can be compared to the high one gets on getting your first paycheck. Not having to depend on your parents for pocket money….Brilliant! You earn and spend as you like. You are the king!
Seems familiar? Just like the feeling you had when you started your career?
This post is my feedback to one of the questions asked in the Personal Finances Survey conducted sometime back. The exact question of a regular reader Nupur, is as follows (edited for brevity):
I have just completed engineering and got a decent job – which pays about Rs 40,000 a month. I am young (21) and willing to invest for future. I read your post on huge cost of delaying investing and don’t want to end up not having anything later on in my life. I want to secure and solidify my finances as soon as possible.
Once again I am positively surprised with the clarity of thought, which the new people entering the workforce have about money. I personally was never so sure about financial solidification and was more fascinated about the stocks and investing in general.
Luckily, when I started my career, I was posted in a very remote location for more than 2.5 years, and which had almost no places or avenues where I could spend my money! And you will be surprised to know that there were many months, where I ended up spending less than 5% of my monthly salary. 🙂
But lets focus now on how Nupur can manage her new-found income source…
For this particular example, I prefer not projecting too long into the future. Its best to weigh the benefits of managing your money prudently in even the first 5 years of your career. And that is because if I can prove that a well-managed cashflow for first five years is a very big win for someone who wants to create long-term wealth, then there is no need to further convince this person…and that is because the reader is already very smart…well proven by the question asked. 🙂
From my personal experience, I have seen that a majority of young people realize about the importance of saving money (and investing) only after a few years of starting out. They don’t even realize and the first few years of their career just rush through in a jiffy. And when they look back and see how much they have saved, there is nothing to talk about. First few years are spent in buying things you always wanted to buy for yourself, but never had the money to do so. You also buy gifts for people you care about and travel and enjoy life. I am not against all this and even I have done this. And then there are those uncles and family friends who will sell you those high-premium insurance plans, which you don’t need. 🙂
Once again I am digressing from the real topic…so lets come back to the topic of how to manage money when starting out in your career…
Now lets see what we know here…
At the age of 21, Nupur starts earning Rs 40,000 after tax.
She would be making some mandatory PF contributions, which would be matched by her employer too. I am assuming this contribution to be 10% of her basic salary. This would have to be matched by her employer. Assuming basic is 50% of the take home salary, total PF contribution (Nupur’s + Employer’s) is Rs 4000 (Rs 2000 each).
Now for evaluating the scenario after 5 years, that is when Nupur turns around 26-27, I have assumed that her salary would rise by a nominal 10% every year.
Shown below is the table, which calculates the amount accumulated in her PF account after 5 years:
Monthly Income Provident Fund
A rough approximate, given the assumptions we have taken are valid, is around Rs 3.7 lacs. Not much considering that her starting annual income was more than that. But significant considering that this has been achieved by giving up just 5% of her monthly gross salary. Isn’t it?
Now this PF amount should not be considered as something that you can utilize in the short term. So it would be a mistake to depend on this if there is any emergency money requirement. And when Nupur switches her job after 5 years, she can get this corpus transferred to her new employer or she can withdraw it. But withdrawing PF is a big mistake, which results in significant damage to the process of wealth creation by compounding.
Now once she gets her salary every month after mandatory PF deductions, she has various expenses. Without getting into the details, I am assuming a decreasing component of expense as a percentage of annual income. Mind you, I am not saying that expenses are reducing. I am saying that as she grows older and her income increases, she will become more and more aware of benefits of reducing her expenses and increasing her savings. Atleast this is what the thought process should be.
So I have taken expenses as 50% of first year salary. Followed by two years of 40%. And remaining two years as 30% of the salary. All the while salary has been increasing at a fixed rate of 10% every year.
Table below details all the calculations about expenses and available surplus:
Monthly Expenses Savings Surplus
As you can see above, the monthly surplus is increasing every year. And this is achieved by a combination of rising income and decreasing percentage of expenses.
Now lets see how this monthly surplus can be managed effectively. I am assuming that Nupur is ready to put full surplus amount into savings and investments as all her expenses have already been taken care off.
Like most Indian parents, Nupur’s parents also (I assume) would be a little apprehensive about stock markets. They must have heard from many people that stock markets are risky and most of the time, people end up losing money. I am assuming this. And basis of my assumption is the general perception which most people of previous* generation have.
* If you are reading this website and are from the previous generation, then you don’t belong to this category and are financially smart and on your way to become rich. 🙂
So Nupur decides to save a small but significant portion (about 25%) of monthly surplus in bank Recurring Deposits. This augers well for her too as it can act as an emergency fund that she can use when required.
Monthly Savings Recurring Deposits
Assuming a nominal 7.5% rate and savings rate of 25% of monthly surplus, Nupur is on her way to amass about Rs 5.6 lacs by the time she has completed 5 years in job.
That was about safer investments (or rather savings). Now Nupur is smart. She knows the real power of investing in equities through regular small investments. So she decides to do a SIP of remaining 75% of monthly surplus in a few well-diversified and proven mutual fund schemes.
And as you can see in table below, her monthly SIP amount is increasing every year. And this is because her income has increased, her expenses as % of income have decreased, and consequently her monthly surplus has increased.
Monthly Investments Salaried Employee
I have assumed a SIP return rate of 11%. Please note that this is just used for calculations, and in reality SIP returns are not such straight-line. They are lumpy. They can be as high as 50% in a year to as low as (-)50%. But average returns for last about two decades in India have been around 15%. So 11% is a safe-enough assumption.
So as depicted in above table, Nupur is on her way to accumulate about Rs 18.4 lacs in her SIP portfolio. Now that is not a small amount for a 26-27 year old to have.
But aren’t we forgetting something else?
Nupur also has Rs 3.7 lacs in PF, Rs 5.6 lacs in bank deposits. Add to this the amount available in her SIP portfolio, she has a networth of Rs 26 lacs.
Even if we were to discount it by 15% for some wrong assumptions and other realities (and I call it Life-Discounting), she would still have about Rs 22 lacs.
And this is for someone who started her career at Rs 40,000 about 5 years back and still does not earn an eye-popping salary. She still earns a decent Rs 58,000.
This shows that if managed well, then it’s entirely possible to reach a decent networth position within a few years of starting your career. Just to give you a perspective, Nupur’s networth position at the end of 5 years is approximately 3-4 times of her then current annual income!! And that is commendable by any standards. And if she continues this approach, she is well on her way to become really – really rich and a Crorepati even before reaching the age of 40.
You would have noticed that in this example, there is not evenone statement that says that she needs to beat the stock markets or anything. And she is actually underperforming the markets when I assumed 11% as the return expected from MF. So even after a theoretically bad performance, Nupur is well positioned in financial terms than 95% of the people her age.
You might say that it would have been wiser for Nupur to purchase a house early on in her career. And you might be right. But I still believe that initial years should be devoted to fortifying one’s finances and accumulating for long term portfolio, than simply paying EMIs.
You might counter-argue that one still has to pay rent, which is an expense. And in case of an EMI, you are paying the money and getting an asset. But we are still paying interest on the loan taken. Right. And interest paid is always an expense. 🙂

But this post is not a discussion about the pros and cons of real estate investing.

The above scenario calculation is what I could think off in response to Nupur’s question. I hope if she reads this, she has some more clarity on what she can do now. As for other readers, feel free to share your own thoughts about the question posed by her.