Home » Opinion » Knowing simple Maths can help you evaluate your finances better

Knowing simple Maths can help you evaluate your finances better

Principles of time value of money can help us evaluate every financial decision
By Narayan Krishnamurthy | February 08, 2017

The first three months of the year are pretty traumatic for several people; especially those taxpayers who still have some room to save on taxes and are unsure of how to go about handling last minute tax savings. So, I had this friend’s nephew, a bright techie who wanted to know if it was a good idea to go in for an insurance policy in which he had to deploy Rs 12,000 a year for three years for him to collect Rs 10 lakh after 10 years. I asked him what made him believe that he would be able to collect Rs 10 lakh a decade from now by paying Rs 36,000 over the next three years.

His instant reply was that the illustration on the excel sheet demonstrated by the agent popped up the results. I find most insurance agents, like several other financial intermediaries, difficult to handle. All of them tend to come up with excel sheet printouts in shades of grey, with rows and columns of figures and assumptions that compute the desired outcome that will tempt the most rational of investors. Some smart intermediaries carry tablets to show their excel sheet prowess by changing the inputs and outputs as if it is a magic show that they are conducting. The exercise is mesmerising and the colours dazzling to make mundane math look so exciting and mouth watering.

Many a times, these people manage to get more than they ask for. For instance, Rs 12,000 a year is basically Rs 1,000 a month, which is simple to calculate for anyone. So, by showcasing a low hanging fruit of Rs 10 lakh in ten years by paying Rs 1,000 a month for three years; they would get the prospect to commit Rs 3,000 a month to receive Rs 30 lakh a decade later. At this juncture, the policy proposal document will come out, and so would a declaration form which would state that the working calculations are indicative and that the prospect has understood that it is not real returns.

 

Temptation takes over

The question that most buyer fail to ask, and something that they should do first is; if the workings are indicative why are they there in the first place, and what could they do if they did not understand them even for their indicative value? Try asking a financial product seller these question and chances are he would not reply to your calls. But, by showing a benefit, even if it is hypothetical and assumed, he managed to draw your interest in putting your money into such schemes.

 I have encountered some very sane and senior bureaucrats who have in the past been lured into plantation schemes and even emu farming, without even questioning the viability. I don’t blame any of them, after all, for a smart salesman, all it takes is to come up with a neat set of colour printed brochure with charts and graphs showing how much their money would be worth in future to sell the idea. Why just insurance, even among borrowers, EMI charts make loans so easy to repay and convenient to fulfil their financial desires. Most do not understand the effective interest versus the quoted rate, or what the principal and interest repayment component mean.

 

Enter spreadsheets

Yes, one may find the mesh of rows and columns to be very intimidating. But, financial transactions based on cash inflows and outflows can be easily understood by filing up an excel sheet. Simple math, now even more simplified with a spreadsheet, can help us figure out the interest rate inherent in the cash flows (a function called Xirr, which you can access by installing an add-in called ‘analysis tool pack’ in MS Excel, can be used to get this number). For instance, the illustration that was shared with my friend’s nephew was actually based on a compounded annual return in excess of 20 per cent. This to a fairly medium risk taker is a strict no.

 It is a different issue that there is clearly no history of such returns coming virtually risk-free and even an all-equity investment has a small probability of falling short by a few percentage points. My suggestion, everyone dealing with any financial instrument, be it savings or investments should make an effort to understand present value and future value calculations on a spreadsheet. Time value of money is an essential must know calculation for every taxpayer, saver and investor.

 Do not be tempted to an investment based just on how much you can afford to invest each month. Likewise, don’t borrow because you can afford to pay a certain EMI each month, which is a fraction of your salary. Broadly, people would love to call themselves as those who either love maths or hate it. But, life is not that simple; everyone in both the camps will need to encounter with finances in a manner that they will need to handle money for their secure future. Learn to use worksheets or use a few trusted online financial calculators. Simple math can not only help you verify the returns promised by investment advisors, it will also help you from being taken for a ride. 

Download the Outlook Money App and read all the magazine stories on your phone!
Play Store and App Store

On Stands Now
Most Viewed