Basic personal finance math

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Dear Readers,

In my last post, I encouraged you to start your investment journey, no matter how small. Many shy away from personal finance because they assume the math involved is too complicated. However, personal finance math is actually quite simple and easy to grasp. All you need is a basic understanding of a few key concepts.

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Let’s break down the essentials.

1. Understanding Absolute Return

The simplest way to calculate the return on your investment is through the absolute return. Let’s say you invest ₹50,000 in a stock in January 2023, and by December 2023, your investment grows to ₹58,000. The return is calculated by subtracting the initial investment from the final value (₹58,000 - ₹50,000 = ₹8,000), and then dividing this by your starting investment. Multiply the result by 100 to get the percentage.

In this case, the return is:

(₹8,000 ÷ ₹50,000) × 100 = 16%

However, absolute return doesn’t account for the time it takes for your investment to grow.

2. The Power of CAGR (Compound Annual Growth Rate)

When the time period exceeds one year, you should consider the CAGR instead of absolute return. The CAGR provides the annual growth rate of your investment over time.

For example, if you invest ₹50,000 in January 2023 and by March 2025 your investment grows to ₹60,000, the absolute return is 20%. But, when you calculate the CAGR, it’s a more realistic measure of growth because it factors in the time taken to achieve that return.

In this case, the CAGR would be 8.78%, which gives a better understanding of how fast your investment is growing.

3. XIRR: When You Invest Regularly

If you are investing in multiple installments, like contributing ₹25,000 each year for three years, you need to use XIRR (Extended Internal Rate of Return) to calculate your returns. This accounts for the fact that your investments were made at different times, giving you a more accurate picture of your growth.

4. Future Value and Present Value of Money

In finance, time plays a critical role. A classic dilemma is: Would you prefer ₹84,000 today or ₹1,00,000 in two years? To make this decision, you need to understand the future value of money.

For example, if a bank offers you 9% interest annually, investing ₹84,000 today would grow to about ₹1,00,000 in two years. But what if you want to know the value of ₹1,00,000 two years from now in today’s terms? By discounting it at the same 9% rate, you would find that it’s equivalent to ₹84,000 today.

Key Takeaways:

- Absolute return is used for calculating growth over one year.

- CAGR measures the growth rate over multiple years.

- XIRR helps calculate returns when you invest at different intervals.

- Future value projects today’s money into the future, while present value discounts future money to today’s terms.

Now that you understand these basics, you are better equipped to navigate your investment journey, whether you're evaluating stocks or mutual funds. Remember, personal finance doesn't need to be complicated. Start small and build your knowledge step by step.

Feel free to reach out if you have any questions!

Best regards,