Financial planning and Maths

Many years back I had read a book called “Surviving Men” by Shobhaa De. It was a fairly cynical take on the male gender but it was overall a good read, would recommend it to both men and women. One of the chapters was devoted to men thinking of themselves as Engineers who could solve every issue themselves. She gave a nice example of a man attacking a TV with a screw driver despite not knowing much about the TV. When I nowadays see a lot of blogs and posts brimming with mathematical formulas to churn complex financial plans, I am reminded of her book.

Now do not get me wrong – I love Maths and have pursued it for many years of my life. First as a student when I did my Engineering and then my MBA and later on as a teacher to my children, where I was pleased to find that unlike many of my friends I could actually teach them till 12th standard. However, I do not believe that any complex level of Maths is needed to understand personal finance. In fact, I will further go on to say that all the Maths you need for a financial plan is normally taught to you by the time you complete your school education.

My problem is not with people who want to believe that financial planning is only about Maths, Excel sheets and nice looking graphs. Each one to himself or herself, as someone has said. In some ways these can also be useful learning tools. The issue starts when such financial planners / experts / advisers start brainwashing other people into believing that all financial plans needed the use of fairly complex Maths and this is either best left to experts or it is better to use available calculators. Again calculators are great tools, but you really do not need them to make a financial plan.

In fact, I will go ahead and say that usage of calculators and financial planners for doing something like a financial plan is actually a bad idea. The basis of a financial plan is to first understand what things are important to you and your family in life and then decide on an investment plan. You need to understand the fundamentals of investment for this, the Maths needed is none more than the high school variety.

The same applies when we talk of equity investing. People will go ahead and give the example of compounding, when it should be obvious to anyone understanding the asset class that the returns from it are non-linear and therefore the principle of compounding clearly does not work for equities, unlike the way it does work for debt products. Yes, equities have been known to perform in the long run but that has nothing to do with the compounding principle. Do you need to understand a lot of Maths for dealing with equities – not at all. A knowledge of mean and standard deviation will help to understand returns and volatility but even if you do not have that, no great harm will be done.

Now you will ask me how do you choose stocks and MF to invest in. Don’t you need to calculate all kinds of ratios to decide on these. Well, if you want to assemble a TV by yourself, then the answer is a yes. For most of us we just buy a TV from a shop, many nowadays buy it even from a website. The point being, there is enough analysis available in the public domain which you can use for making your investment decisions. You really do not need to fire up an Excel sheet and try to figure out all kinds of ratios. Firstly, it is a fairly time taking exercise and secondly, there are better people than you who are already doing that. For stock selection, you do need to understand the business and believe me, that is far more involved as compared to working out some ratios on an Excel sheet. For MF selection, just decide on the category of funds and then choose any of the top rated funds from the plethora of web sites available.

For creation of the plan numbers all that you really need to understand is the Compound interest formula and the different variations of it. Even this is not needed if you are able to select the right tool from the internet. But the more important issue here is that, often people give wrong and misleading information to potential investors. Let me give a relevant example.

Some time back there was a post saying that Balanced MF had a better chance of providing superior returns as compared to a large cap or Mid cap based MF. HDFC Prudence CAGR over some period was cited as an example to prove the point. Now, I normally do not get into such discussions but in this case the misleading seemed to be a bit too much, I agree it could have been inadvertent. As most will know, Balance funds invest partly in debt whereas pure equity funds invest wholly in equity. So to make the statement true in a Bull market ( like we had in 2014) 65 Rs worth of stocks in the Balanced fund would really have to do better than 100 Rs of the other fund ( not accurately). In other words if debt return was 8 % and equity 12 % then Balanced fund return would be 10.67% and pure equity fund would be 12 %.

So what do you really need to be a good practitioner pf Personal finance and being able to invest well? To start with a lot of common sense, ability to learn for yourself, use simple concepts well and trusting the actual experts where you need to trust them. Complex Maths and bombastic financial jargon will not really help a great deal, more importantly it is not needed.

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4 thoughts on “Financial planning and Maths

    • Look at Tata Steel price in 2007 and where it is now. See how Kingfisher Airlines has declined completely. Equity movement can be in both directions and there is no guarantee at all that there will be gains even after long years for an individual stock.

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      • Ok. Do you mean to say compounding doesn’t work in individual stocks as well as equity mutual funds? or just individual stocks

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      • Mutual funds have a portfolio so the chances of losing are less there. Understand that both stocks and MF will have growth BUT that is not compounding. You may have several years of declining or sideways markets where there are hardly any returns and then there can be 2 years of super profits. trying to explain this by an average CAGR is a wrong way of understanding this.

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