Consider the following problem.
Two trains are running on the same track. The only issue is they are running towards each other. It is apparent that they will collide at some point.
Now, there is a fly which is happily flying between the two trains. The problem is what is the total distance that the fly will be able to cover before its crushed.
The speed of Train 1 is 60 km/hr while the Train 2 is running at a speed of 40 km/hr. The distance between the two trains is 20 kms. The speed of the fly is 10 km/hr.
This appears to be a complicated problem. Is it?
What approach will you take to solve the problem?
…
As you now know, this problem can be solved using some basic school maths. Yes!
The formula to use is Distance = Speed * Time.
Do you remember this simple formula from school?
Go ahead and apply it to the problem.
However, to make you solve this problem is not the purpose of the post.
What if I tell you that this very formula has an important role to play in your investing decisions too?
Investing math – The role of Distance, Speed and Time in investment decisions
Let me just bring this into perspective. With respect to investing, the variables in the equation are:
Distance = Goal Value
Speed = Investment rate of return
Time is, of course, time.
In an equation form, it is
Distance or Goal Value = Speed (Rate of return and Amount) * Time
Any two variables of the equation can be changed to get a result for the third variable. However, we will focus on the speed. Let’s see how it works out.
Investing math – What’s the Speed?
The rate of return is something that most investors work with. Everyone wants the maximum return with minimum risk.
Going back to the basic math question, suppose you have to reach a destination which is 150 kms away. You estimate that with an average driving speed of 60 km/hr, you would take about 2.5 hours to reach your destination.
In case you have only 2 hours to reach, you would need an average speed of 75 km/hr.
Similarly, say, you have to accumulate Rs. 1 crore in 10 years and you are willing to invest Rs. 50,000 per month. The speed or the rate of return your investment needs to earn to reach this amount is 9.5% per year.
This return is likely to be achieved with an equal combination of debt and equity investments. You do not need to expose yourself to high risk and keep your portfolio stable.
Now, if you want to achieve this goal 2 years earlier, that is in 8 years instead of 10 years, your portfolio has to earn 17% per year. That’s a huge jump in requirement.
This is like pressing the accelerator hard to touch top speed. Imagine yourself doing that in your car/bike.
From an investment point of view, it means you need an almost 100% exposure to equity, or a 100% exposure to volatility. Are you ready for that?
What’s the right speed for you?
Only you can answer this question. What speed are you comfortable with?
Going back to covering a physical distance, you are probably more comfortable with a 60 km/hr average speed that does not lead to unnecessary jerks and decreases the chances of an accident significantly.
There will be others who would want to clock a 90 km/hr average speed.
Put your investment returns in a similar perspective. A higher return will come with its own share of ups and downs or volatility. Yes, you may want to outpace and outperform your colleague or relative and lose your sleep over it. Great, if it works for you.
Or will a lower but steady return give you comfort and let you sleep peacefully at night? The other side is that you may not reach your destination in the specified time.
The key is to figure out “your own pace.”
Let’s hear it from the master, Seth Godin.
“Speed is relative”, says Seth Godin in one his recent blog posts.
“There’s not an absolute speed, a correct velocity, a posted limit or minimum for all of us. It’s relative.
Given that, how does your speed match your goals and your strategy? Not compared to everyone else, but compared to the one and only thing you have control over?
Passing the slow cars on the road is an illusion, a chance to fool yourself into thinking you’re making good progress. To a sloth, even a loris is a speedster.
Pick your own pace.”
Lesson: You don’t need to be a math wizard to solve your investment problems. Basic investing math can help you make the right decisions.
Now, whatever you do, avoid being the fly between the two trains. Assess carefully what rate of return (speed) will work for you with respect to the time available and the goals to be achieved aka distance to be covered?
Once you have figured out the required return, you can then focus on the specific investment instruments. Flipped around, each of the investment instruments you buy should be evaluated against the return you want to reach your financial goals.
BTW, how much distance did the fly cover?
Dear Vipin Sir,
Different individuals have different risk appetite and based on their risk appetite, one should invest in equity mutual funds, I guess the post is related to equity mutual funds, for instance, if you ask me, then, I would say the average speed in developed countries on high ways is 120-140 km/hr as roads are bigger and wider and rules and regulations are followed almost by every one, so in my perspective, if a person is well placed with finance with zero liabilities and if a person is investing keeping goal in mind for long term, then, high volatility can be your friend, the more the risk, more is the return, there are only few funds with exceptional performance giving high returns and at the same time take risk may be 2 to 3 % less than other funds in the same category.
In this context, what I would to say is like you pointed out that if we travel at 60 kms/hr, we will not meet up with accidents applies to individual’s financial status and if some one is willing to go at a speed of 120 kms/hr per hour then he/she should be prepared to loose upto 70% in worst case out of investments made in high risk mutual funds.
As one equity mutual fund will have atleast 25 stocks on an average, the chance of losing 100% of your invested amount is seldem, if all companies will go bankrupt, then, it would be the case of 3rd World War and everything would fall irrespective of category in that kind of situation.
Disciplined investing for long tenures can be a blessing as one would ripe benefits by buying units at different NAVs and eventually create wealth and that too beating inflation.
Equity mutual funds are not that riskier as Advisors project them to be, take any high risk fund within any category for the past 8 to 10 years and even after turmoil in years 2008, 2011, 2013 and recent corrections in 2016, none of decent performing funds have given any negative returns and returns are above 12% per annum on an average, so what this means, if you are investing regularly for longer tenures more than 7 years, then, choose equity mutual funds, if tenure is less than 7 years, never choose 100% equity instead go for a combination of debt and equity in ratio of 30: 70.
Again it all depends on individual risk taking capacity.
A bit long but I hope this is informative enough for all readers!!!
Thanks.
Bhaskar Nimmala
Thanks for the detailed comment Bhaskar and sharing your thoughts.
Zero. If the fly can do only 10 km/h and the trains are going faster, the fly will get crushed the instant it takes off.
Not really, it got to fly for some time.