Investing is a complex term and a daunting exercise for the common man. In this article we try and make things simpler. Understanding numbers is not rocket science.

Say, Mr Investor lends Rs 100 to a friend at an annual interest of 10 per cent. The return for the first year is Rs 10. The total amount at the end of the first year equals principal of Rs 100 and interest of Rs 10, making the available balance Rs 110.

In the next year, Mr Investor will earn another 10 per cent on his Rs 110 at the beginning of the second year . So the interest he earned in the second year was Rs 11. The total interest earned by Mr Investor for two years was Rs 10 plus Rs 11 totalling Rs 21.

Here we are talking about compounding returns or interest and not simple return or interest.

Rule of 72

There is a thumb rule called the “Rule of 72” that gives us a very reasonable idea of the approximate time-frame over which our money doubles. Just divide 72 by the rate of return or interest rate.

Here's an example. Say, the National Savings Certificate (NSC) scheme promises an annual return of 8 per cent. Dividing 72 by 8 we get 9, which is approximately equal to the time-frame guaranteed by the Postal Department.

Another way to use this rule is to guess the rate of return that you must get for an investment to double within a particular period. Say, Mr Ramesh wants to buy a house after six years for a budget of Rs 30 lakh. He has Rs 15 lakh with him now. He is wondering how much he needs to earn every year to achieve this. Simply divide 72 by 6. Mr Ramesh thus needs to make investments in assets that can fetch a compounded return of 12 per cent to achieve his goal.

Recovering from losses

Recovering from a loss requires a greater percentage change when compared with the percentage loss of value. Take Mr Money. He has a net worth of Rs 10 lakh. Then markets turn bad and let's assume he loses 15 per cent of his net worth. It now stands at Rs 8.5 lakh. How much return should Mr Money earn to get back to his initial portfolio value?

He needs to now earn Rs 1.5 lakh, translating into a return of 17.6 per cent. So, the point is, if you suffer a loss of ‘x' per cent on our portfolio, you need a gain of more than just x per cent to get back to the initial investment.

Compounding

Earlier, we discussed 10 per cent interest a year. What is interest being compounded half-yearly? Basically, it tells us how many times our interest will be calculated. For instance, an interest rate of 10 per cent compounded half-yearly means that interest will be calculated every six months. Here, 10 per cent is the nominal rate. It implies an effective half-yearly interest rate of 5 per cent.

Say, you have Rs 10,000. The interest for the first six months works out to Rs 500. For the next six months, you have to take into consideration Rs 10,500. The total interest for the year is Rs 525, Rs 25 more than if the interest was compounded yearly. The importance of this concept can be well appreciated if the duration and amount of investment is large.

(The author is CEO, BankBazaar.com)

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