what is personal finance explained with example

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Marketopedia / Why is managing personal finance important? / what is personal finance explained with example

Here’s an example with the help of a story of 3 sisters that will help you understand why it is essential to begin setting aside funds as soon as possible.

A father of triplets decided to grant each daughter Rs.50,000/- on their 20th birthday and every year until they were 65 years old. He left it to them how they would use the money.

As a wise father, he advised his daughters to put their money in a promissory note, which offered a 12% compounded annual return. The condition was that once the money had been invested, they could not withdraw it until they turned 65.

The triplets had a distinctive approach to finances. One daughter saved, another invested, and the third spent her income. Each of them utilised their money according to their individual preferences.

– On her 20th birthday, the 1st daughter invested the first nine 50Ks that she received through a promissory note. However, with each passing birthday thereafter, she spent the additional 50K on frivolous things until her 65th birthday.

– The second daughter began by blowing through all the money she got. But when she hit 28, she took a more mature approach and started setting aside the same amount as her sister. She kept up that saving streak for eight years, then returned to her spending ways until her 65th birthday.

– When the third sibling hit her 28th birthday, she became more serious and decided to invest the 50k cash until she reached 65 years of age. All the money received by her father had been spent before this resolution.

This is a brief overview of how the sisters chose to use their funds:

– For the first 9 years, the eldest sister diligently saved, amounting to Rs.450,000/- between her 20th and 36th birthdays.

– For nine years, the second sister dedicated herself to saving money; from her 28th birthday to her 36th birthday, she managed to amass a total of Rs.450,000.

– From the age of 28 right up to 65, the 3rd sister diligently saved an impressive Rs.1,900,000/-.

Now, I want to know, on their 65th birthday, which sister do you think would have accumulated the most funds? Bear in mind that when this money is invested with a promissory note, it will remain locked in there until that special occasion. Not to mention, the promissory note provides a compounded rate of return of 12% annually.

It is likely that this is what comes to mind when considering this:

– The first sister started saving too little at the beginning, so she would not have saved a great deal.

– The 2nd sister has been sparing with her savings, so it is unlikely she will have a great deal to celebrate when she turns 65.

– The youngest sibling, despite starting their saving plan later than the others, has amassed a considerable amount of money over the years and must therefore have the most savings when they turn 65.

I wouldn’t be shocked if our approach to savings is linear since we usually equate future value to the amount saved today. However, we need to consider two more elements – time and return – which produce stunning results when blended together in an intricate nonlinear method.

The three sister problem presents some surprising numbers, so prepare to be taken aback.

– The third sister carefully saved 19L over her lifetime, and by the time she reached 65, this had grown to an impressive 3.05Crs!

– The second sister invests 4.5L, and by the time she turns 65, it has grown to an impressive 1.98Crs.

– The first sister makes a significant saving of 4.5L, ultimately leading to her having an impressive total of 4.89 Crores by the time she reaches the age of 65!

Are you feeling confused?

I’m sure a few of you might be giving this your attention, so please take note of the following –

The first sibling accumulated a comparable sum. However, the time they both invested in it differed; the first sister contributed 45 years of growth, while the second had 38. Look how much of a difference this makes! I regret not setting aside money early on in life – such an action could have impacted my finances immensely.

The 3rd sister ultimately achieved the second-largest corpus, but in order to do that, she had to save for an extended period. However, her portfolio was still inferior to the 1st sister’s.

If you, like me, missed out on saving early on, then now your best bet is to save consistently over a longer period.

I’m sure you understand the importance of beginning to save early. Utilizing the power of time can make an incredible difference, so why not start now?

Wait a moment – how did I calculate the growth of money for each sister? How did I work out that sister 1 saved 4.89Cr and sister 2 saved 1.98Cr?

This concept, ‘Time the value of money’, is the foundation of personal finance and, therefore, must be understood from the outset. We will cover time value and its application in greater depth in the following chapter.

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