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Most of us know Warren Buffett as the world’s most famous investor. But how many of us know that Buffett has become one of the world’s richest men by using one simple secret.

 

“What’s that secret?” you may wonder.

 

Well, here is a video that will reveal that secret to you…
 
 


 

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Buffett’s Secret – Power of Compounding

In his 1962 letter, Buffett shared the story of Queen Isabella of Spain sponsoring Christopher Columbus’s voyage in 1492 to find a “new world” at a cost of around US$ 30,000.

 

Buffett called it a low-compound investment, as the same money invested at 4% compounded annually would have amounted to something like US$ 2 trillion by 1962 (or 470 years later).

 

Then, in 1965 letter, he wrote – “…the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal


However, the Indians have only had to achieve a 6 1/2% return to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.”

 

After reading this, you may wonder, “All this sounds fanciful. Who lives 300-400 years to benefit from such compounding?”

 

Well, you don’t need to live so much to benefit from the power of compounding.

 

Just 25-30 years are enough, but you need to know how to use it well.

 

In the above video, we showed an example of how an investor can benefit from the power of compounding in the long term.

 

Here is another example that will show why you must not delay in benefiting from this eighth wonder of the world.

 

The Case of Jai and Veeru


Let’s assume there are two young men, Jai and Veeru, who begin their careers at the age of 23.

 

Jai starts saving money from the very first year of his job, and invests Rs 6,000 each year for 10 years.

 

He earns 8% return for these 10 years, and ends up with Rs 87,000 at the end of this period (on a total investment of Rs 60,000).

 

Now, he stops saving any more money after these 10 years, and plans to leave whatever he has saved as it is and till he is 60 years old.

 

He calculates that his money, if it continues to grow at 8% per year for the next 27 years (till he is 60), will grow to around Rs 694,000.

 

Now, let us look at Veeru’s case.

 

Even as he, like Jai, starts working at the age of 23, Veeru spends his entire salary for the first 10 years and saves nothing.

 

On the advice of Jai, he finally starts investing when he is 33 years of age, and wants to have the same amount of money as Jai when he is 60.

 

He calculates that he would need to save Rs 7,950 for 27 years – from 33 years of age to 60 – to reach Rs 694,000.

 

Let’s see the difference now.

 

In total, Jai, who started investing Rs 6,000 at 23 and stopped when he was 33 but left his money to grow, had to invest Rs 60,000 out of pocket to reach Rs 694,000 at age 60.

 

Veeru, on the other hand, had to invest a total of Rs 214,650 (Rs 7,950 x 27) out of his pocket to reach that level.

 

Now the question is – Why did Jai score over Veeru with lesser money invested from his pocket?

 

The answer – All Jai did was start early, and let the power of compounding work its magic in the long term.

 

The lesson for you is simple – If you can start saving and investing your money regularly from a young age, and continue to do it sensibly, the amount of wealth you will have after 25-30 years will be huge and more than enough to meet your financial goals (like your retirement, or a child’s education and marriage).

 

In fact, our calculations show that if you can save just Rs 1,500 per month, and let this money compound at 12% return every year for 25 years, you will end up with around Rs 28 lac at the end of this 25-year period!

 

If your money can earn 15% return per annum instead of 12%, your monthly investment of Rs 1,500 that you make for 25 years, would grow to a huge Rs 49 lac!

 

Isn’t that amazing?

 

Well, before we end, here are two key lessons you must not forget when it comes to the power of compounding and how it can benefit you in the long run –

 

  1. Time and money are great friends: If you can leave you money to spend a long time with time, they can work wonders for your wealth. Just start investing as early as possible instead of waiting till you grow older and have less time to compound your money. Even a 10-year delay can cause problems for you, as we saw in the case of Veeru.

 

  1. Marginally higher rate of return creates huge difference: As you just read above, Rs 1,500 per month invested at 12% for 25 years will leave you with Rs 28 lac. Just 3% higher return, i.e., 15% for 25 years will leave you with a much higher Rs 49 lac!

 

That is why, if you want to invest your money for the long run, say 15-20 years, invest it in assets that have the probability of giving the highest long term returns.

 

One such asset class is equities or stocks.

 

Instead of trading in and out of stocks and mutual funds, if you can keep investing with discipline over 15-20 years, you will end up with a huge wealth.

 

That’s the power of compounding, and as you realize, it indeed is the eighth wonder of the world.

 

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Suyash Choudhary

The RBI cut repo rate by 25 bps to 7.25% as was expected by consensus. There was no change to  CRR. HTM has been cut by 2% to be implemented in gradually in 50 bps moves every quarter starting June. Besides, the following indicative projections for various macro-parameters were given for the year:

 

 

– GDP for 2013 – 14 pegged at 5.7%

– RBI to endeavor to condition evolution of inflation to level of 5% by March 2014. Importantly, this is not a projection as is traditionally given but seems more like a ‘statement of intent’

– M3 growth for 2013 – 14 projected at 13%, and deposit growth at 14%

– Growth in non-food credit projected at 15%.

 

The policy and the pre-policy document before it, underscores largely the same points that the RBI has been making consistently over the past few months.  These are largely as follows:

 

– Growth is a major concern but hinges to a large extent on investment revival. Here, the RBI’s incremental role is limited and in fact previous rate cuts have also not had much impact. Rather, the government has a much larger role in terms of focusing on relieving supply bottlenecks, better governance and continued focus on fiscal consolidation. RBI has gone in considerable detail as to where all supply bottlenecks exist including in coal and electricity generation, telecom, roads etc. While government has made tangible efforts towards fiscal consolidation, overall fiscal deficit is still high and there is risk of slippage due to revenue slowdown if growth remains subdued. Finally, the government has to allocate more spending on investments while reducing revenue expenditures so that overall fiscal deficit doesn’t rise.

 

– WPI inflation has fallen, core WPI even more so reflecting subdued commodities, stable rupee, and lack of pricing power. However, pass through pressures may arise from coal, electricity and diesel as these adjustments continue. Furthermore, food inflation still remains high. Most importantly, CPI remains in double digit thereby causing ‘wedge’ between CPI and WPI to widen further. The new input in this discussion in this policy seems to be RBI’s determination to bring WPI towards its threshold of 5%. This suggests that the central bank doesn’t perceive that the recent fall in WPI (and more to come in months ahead) necessarily provides much more room to monetary policy. In fact the indicated trajectory builds for WPI to be range-bound around 5.5% with some undershooting in first half of the fiscal and some increase in the second half.

 

– External risks as first focused upon in January remain a primary concern; notwithstanding recent fall in trade deficit and softer commodities indicating further narrowing ahead. The RBI’s comfort on current account deficit (CAD) is towards 2.5% of GDP. The worry, so far as the deficit is much higher, is that of sudden changes in capital flows to the country.

 

Given all of these, the RBI assesses ‘little space for further monetary easing’. In fact it even says that risks from CAD and its financing could ‘warrant a swift reversal of the policy stance’.

 

Assessment and Implications

Even though RBI has sounded much more hawkish than general market expectations, the developments today are very much in line with RBI’s recent framework the way we have interpreted it.  This framework suggests a shift somewhat from the traditional growth versus inflation trade-off towards thinking about actual real world utility of further rate cuts. We had indicated some of these counterpoints recently (refer our note “The counter-logic to current interest rate expectations” dated 29th April). If anything the RBI has tightened its framework more today given that it wants to condition market towards 5% WPI inflation. To recall, a sharp fall in WPI inflation recently is the largest driver currently for market’s future rate cut expectations. However, if the central bank seriously pursues a 5% WPI conditioning, then actual prints have to start undershooting that mark as well for scope of rate cuts to open up. To be sure, the scope for even this happening exists over the next few inflation prints given the significant commodity price correction and loss of inflation momentum recently. Also, as we have seen over April, market memory is typically short and the current RBI hawkishness may soon be forgotten in face of continued weakening of economic data. For this reason, government bond yields may be better supported even in the face of supply than the pure implication from today’s assessment may suggest.

 

However, the point is really very different. Barring a brief move towards 8%, government bond yields have been stuck between 7.75 – 85% now since February. This is largely because the period of limited  net supply of government bonds since late last year has given way with fresh supply starting from April. In the same period, front end corporate bond yields have come off by upwards of 50 bps. This is in line with our expectations and our underlying hypothesis that we would rather play ‘seasonality’ than rate cuts given the extra-ordinary nature of this cycle. While we remain overweight 1 – 5 year in our bond funds for now, we may gradually look to build further on longer end (government and corporate bonds) as additional supply kicks in over the next few months. Meanwhile, we would reiterate recent advise to investors to match risk appetite and investment horizon to their investment decisions; irrespective of short bursts of performance from various categories of fixed income funds.

 

Disclaimer:
 
The Disclosures of opinions/in house views incorporated in this document is provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. The recipient should take this into account before interpreting the document. This report has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / Board of Trustee/ IDFC Asset Management Co. Pvt. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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