Category: Investments

Thiyagu posted an interesting comment the other day where he said that he held some shares of L&T Holdings, and when L&T divested its stake in L&T Finance he expected to automatically get shares in L&T Finance but was disappointed when he didn’t get any.

So, the question is under what conditions should you expect to get the shares of another company automatically?

I think this is most easily understood when you think of yourself as the owner of the company because as a shareholder that’s what you really are.

If you owned L&T which in turn owned L&T Finance – the value of L&T Finance is implicitly accounted for in the value of your L&T holding.  And if you decide to sell L&T Finance to someone you would expect cash for it and not shares of L&T Finance.

In terms of a company doing this — L&T divested a part of its stake in L&T Finance and got cash for those shares which went in their balance sheet. No one got new shares in L&T Finance by virtue of owning L&T itself.

It is most common for shareholders of one company to get shares of another company during takeovers and mergers. It is common for the company that’s buying to pay through cash and shares, and that’s when as a seller you get new shares.

When Facebook bought Instagram, the shareholders of Instagram were paid in cash and stock so if you owned shares in Instagram you would automatically get shares of Facebook because of this deal.

Similarly during merger of two companies, the shareholders of the companies get shares in the new company at a predetermined ratio which is usually based on how big the original entity was compared with the new entity.

As I said earlier, this is most easily understood when you think of yourself as the owner or seller of the company and think in terms of what you would have wanted in this transaction had you owned the whole company instead of a few shares.

This post is from the Suggest a Topic page

IDBI is coming out with a new mutual fund called the IDBI India Top 100 Equity Fund, and this fund will be a diversified equity fund which will invest in stocks selected from the CNX 100.

What will IDBI India Top 100 Equity Fund invest in?

The CNX 100 is an index that’s a combination of the Nifty and Nifty Junior so this diversified equity mutual fund will have pick and choose from the 100 biggest companies listed in India. The fund will invest not less than 70% of its assets in equity products, and the remaining in debt products.

So, the fund is geared towards big companies in India, and to that extent the universe of the fund is quite limited. This may be comforting to people who know that the fund won’t invest in smaller more volatile companies, and disappointing to people who think that the fund doesn’t have too many options for diversification and will probably feature the same names that most of the existing funds have today.

I think both point of views are fine as long as you know what you are getting into.

NFO Dates, Investing Options and Exit Loads

The NFO started on the 25th April 2012, and will end on May 9th 2012. You can invest a minimum of Rs. 5,000 in the NFO and there’s going to be a growth and dividend option that you can choose from.

You can set up a monthly SIP for Rs. 500 or more or quarterly one for Rs. 1,500 or more.

There is an exit load of 1% if you sell your fund before a year and this exit load is applicable in case of SIPs also as well as when you switch to another fund.

Expense of the fund

All mutual funds charge expenses to its investors which means that they take a certain sum out of the fund every year to meet expenses. The lower the expenses, the better it is and these expenses are expressed as a percentage called expense ratio.

The expense ratio listed for IDBI Top 100 in its document is 2.50% which is fairly high and I don’t see why someone should pay so much in expenses for a fund that has no track record and that will only invest from stocks that are chosen from Nifty and Nifty Junior.

While I can see how the composition of this fund might be drastically different from a Nifty Index Fund, the reality is that most active funds aren’t able to beat their indices and it’s hard to see why someone should pay a relatively high fee to find out whether this fund will be able to do that when they can invest in other funds that have a lower fee and a much longer track record.

 

Between Options and Futures – I would say that Futures are a lot easier to understand than Options since they pretty much work in the same manner as shares. A Future is a contract between two people that has to be settled sometime in the future and with respect to the Indian stock market, here are the important things that you need to consider.

1. Not all stocks have Futures: There are only a handful of shares that have Futures traded on them and you can buy or sell Futures only on those shares. You can look at the list that your broker offers to see if you can trade Futures in a particular stock or index or not.

2. Futures have an expiry date: All Futures have an expiry date, and in India you can buy Futures of three durations – one that expire in the current month, one that expire in the coming month, and a third one that expires in the third month. All Futures contract expire on the last Thursday of the month. So, while in April you can buy an April contract that will expire on 26th April 2012, the May Future will expire on 31st May 2012 and the June Future will expire on June 28th 2012.

3. Futures are traded in lots: You can buy or sell one share of Infosys but Futures have predetermined lots and you have to buy or sell in those many multiples of shares. For example, an Infosys Future has a lot of 125 so when you buy one Future contract of Infosys – it is like buying 125 shares at a go.

The big difference however is that you won’t have to actually pay the price of 125 shares, but only cough up a margin amount which is usually a lot less and depends from one share to the other. Volatile stocks need more margin and less volatile shares need lesser margins.

4. You pay or get only the difference in value in Futures trading: Say you buy Nifty Futures on April 17 2012 when they were trading at Rs. 5,321; one Nifty lot is of 50 shares. Now, if this moves up by 20 points and reaches 5,352 and you sell the Future – you will net 20 x 50 = Rs. 1,000 as profit. On the other hand if it went down by 30 points and you decided to sell you will have to bear a loss of 30 x 50 = Rs. 1,500. If the margin requirement for this contract is 11% then you should have about Rs. 30,000 (11% of 50 x 5321) in your account to take this exposure. If the exchange or broker finds that the money in your account is less than the margin then it will automatically square your position (they will sell it if you bought the Future and buy it if you sold the future).

You can sell your Future at any time before the expiry and on the day of expiry your Future will be cash settled which means that you will either pay the difference if you are in a loss or you will be paid the difference if you are in profit.

5. You can sell a Future without owning it first: Since a Future transaction is settled on a upcoming date, it is possible to sell a Future without actually owning it. This is called going short and this is a useful feature of Futures since you can’t go short using a stock.

For example, you could sell a June Future today without owning it first, and you have till June 28th to buy back your Future and square your transaction. In this case you make profit when the price of the share goes down because you have already sold the share and are hoping to buy it back at a lower price.

Theoretically, this is more dangerous than buying a Future because there is no limit to how high a share can go. Practically, the limit is as much money as is present in your account and allocated for margin. Once your margin is triggered – the broker will square your transaction by buying back the share, and I think you should only buy or sell a Future if you are sure you can track it very closely throughout the day and if you can handle the volatility and price difference. If you’re buying so many Future contracts that your margin is close to being triggered you will never be at peace and even daily volatility can trigger a sale and make you lose a lot of money very quickly. In fact, it might just be better to buy Options instead of Futures because then your loss is defined.

I think I have covered the basics of Futures and if you have any questions then a leave a comment and I’ll answer that. In the next part I’ll take up how Options work.

• Part 1: Introduction to Futures and Options
• Part 2: How do Futures Work?
• Part 3: How do Options work?

Contra is short for contrarian and the idea behind contra mutual funds is to invest in shares of companies that aren’t popular and have lost favor with investors.

There are several contra funds in India, and I think it is fair to say that they have not really invested in a contrarian manner. If you look at their top holdings, you will find big names that everyone is aware of and are commonly owned by a lot of other mutual funds as well.

Here is a list of all contra funds that currently exist in India along with their top 5 holdings.

1. Kotak Contra Fund: Here are its top 5 holdings as on February 29, 2012 (the latest data that I could find.

HDFC Bank	6.24%
Infosys	6.03%
ITC Ltd.	5.76%
HDFC Ltd.	4.38%
Power Grid Corporation Limited	4.31%

2. L&T Contra Fund: Here is the top 5 holding data as on March 31 2012.

Reliance Industries	6.15%
ICICI Bank	5.50%
GSK	4.75%
Federal Bank	4.03%
ITC	4.01%

3. Religare Contra Fund: Top 5 holdings of Religare as on February 29th 2012.

Infosys Ltd	6.04%
Reliance Industries	5.39%
ITC Limited	5.03%
ICICI Bank Limited	4.92%
NTPC Ltd.	4.40%

4. SBI Magnum Sector Umbrella Fund – Contra: Here are the top 5 holding of this fund as on February 29, 2012.

ICICI Bank	7.45%
Dr. Reddy’s Labs	4.10%
SBI	4.09%
Bajaj Holdings	4.03%
Exide	3.39%

5. UTI Contra Fund: Here are the top 5 holdings of the UTI Contra fund as on February 29, 2012.

Infosys	7.29%
ICICI Bank	5.73%
ITC	5.58%
Reliance	5.19%
Tata Motors	4.84%

6. Tata Contra Fund: Here are the top 5 holdings of the Tata Contra Fund as on March 30, 2012.

HDFC Bank	6.77%
Infosys	5.44%
Sadbhav Eng	5.37%
CRISIL	5.22%
GSFC	4.68%

If you look at the shares that these contra mutual funds own, nothing remarkable jumps out at you and these are the same names you would expect to find in any other mutual fund that invests in equity in a diversified manner.

I haven’t included the expenses or returns of these funds, but having researched this data – I can see that they aren’t particularly impressive either.

I don’t really think of any of these funds as contra funds, and if I bought them ever I would think that I have bought a diversified mutual fund which has the word “contra” in its name and nothing more.

In fact I’m not quite sure whether you should buy something just because it is contrarian and how sound that philosophy really is. You should buy a share because you see value in it not because no one else owns it or you may just find that there was a good reason why no one else owned it!

I write about ULIPs very rarely, but in the last year or so, several people have commented that under some circumstances ULIPs are a suitable investing option, and when Roopa posted a comment inquiring about the ICICI Pru SmartKid Premier ULIP in the Suggest a Topic page, I thought it’s finally time to read up on this and do a review of this product.

Insurance and Investment

ICICI Pru’s Smart Kid Premier is a ULIP that combines life insurance and investment, and the way it works for the life insurance part is that you choose whether one or both parents have to be insured, and based on that on the death of the parent – the insurance policy pays you out. This is called the single life or joint life option under the plan.

The insurance pays out a sum assured and it also waives off the future premiums that you would have had to pay under the policy, and you continue to get benefits as if the premiums had been paid.

And how much is the sum assured using this option?  The minimum sum assured is the higher of these two amounts:

• Ten times the annual premium or
• 0.5 x policy term x annual premium

These two options exist because you can decide on a plan where you pay for only 5 years but the plan has a term of 10 years.

So, if you took out a policy with a premium of Rs. 50,000 per year for 10 years, then then sum assured will be Rs. 5 lakhs in this case. Goes without saying that this cover is a lot less than what you get from a term insurance, but then there is no investment angle in term insurance either. Now, let’s get to the investment aspect of this policy.

ICICI Pru Smart Kid Premier Investing Style Options

After they have taken away some money as expenses towards the plan, the remaining sum can be invested in a choice of funds based on three different strategies that you can opt for.

1. Fixed Portfolio Strategy: This is the first of the available strategies, and if you select this strategy, you will have the choice of actively managing your portfolio, and you can pick and choose from 8 funds that they have on offer.

The 8 funds they have on offer are the following:

Fund Name	Asset Allocation
Opportunities Fund	Equity: 80% Debt: 20%
Multi Cap Growth Fund	Equity: 80% Debt: 20%
Bluechip Fund	Equity: 80% Debt: 20%
Multi Cap Balanced Fund	Equity: 60% Debt: 40%
Income Fund	Debt: 100%
Money Market Fund	Debt: 100%
Return Guarantee Fund	Debt: 100%
Dynamic P/E Fund	Invests in the ratio of debt and equity based on the P/E range of the market

I think the name is a little misleading for this strategy because nothing is fixed here, and you have to actively manage which funds you are going to buy into.

 2. Life Cycle Based Portfolio Strategy: The second strategy that you can choose is the life cycle based portfolio strategy and in this strategy the fund moves around your money from an equity based mutual fund to a debt based mutual fund according your age. So, if you are between 26 and 35 years then the fund will have 75% of your money in the multi cap growth fund, and 25% in an income fund, but when you reach the age of 36 – that ratio will be changed to 65% and 35%. So as you get older, more of your money comes out from the equity fund and moves in to the debt fund.

3. Trigger Portfolio Strategy: In this strategy, 75% of your money is invested in the multi cap growth fund and 25% is invested in an income fund. If the equity market rises then part of your profits are redeemed and the money is invested back in the income fund so that any downward movement doesn’t eat into your profits. If the market goes down then new money is used to invest in more equity funds such that they can maintain a 75% – 25% ratio.

To sum up whate we have seen so far, the insurance is ten times your premium and then after they deduct expenses, they allow you to choose one of these three strategic investment options. The next question is how much are the expenses of this plan.

ICICI Pru Smart Kid Premier Expenses

Just like other ULIPS, there are charges under several different heads in this one too, and I’ll list them down in this section.

Premium Allocation Charge: 2% of the premium in the first year will be deducted under this charge, so if you took a policy out for Rs. 50,000 then Rs. 1,000 will be deducted from the policy during the first year for this charge. This will be zero from the second year onwards.

Fund Management Charge: 1.35% per annum will be deducted from the fund value you invest in all the funds except for the return guarantee fund where it is 1.50% and the money market fund where this percentage is 0.75%.

Policy Administration Charge: 0.47% per month will be charged from the premium as this expense from the first year to the time you are paying the premium. When you stop paying the premium (but the term still continues) this will become 0.10% every month.

Mortality Charges: These will also be deducted monthly and they have a table for this that they refer to for determining how much will be reduced. Naturally, if the life of both parents is covered the mortality charges will increase (not by double though).

Switching Charges: You have four free switches in a year, and I think this refers to switching between portfolio strategies, anything over this will be charged Rs. 100 per switch.

Miscellaneous Charges: Policy alterations will be charged at Rs. 250, and I’m not quite sure what type of policy alterations this includes.

How do these expenses affect returns?

The policy brochure has got the following illustration which shows you sample returns at 6% and 10% for two policy terms which are net of all charges, service tax and education cesses.

• Age at entry: 30 years
• Annual Premium Amount: Rs. 50,000
• Mode of Payment: Yearly
• Coverage Option: Single life
• Choice of Portfolio Strategy: Fixed (Money invested in Dynamic P/E fund)
• Premium Payment Option: Regular

	Term = 10 years		Term = 15 years
	Returns at 6% p.a.	Returns at 10% p.a.	Returns at 6% p.a.	Returns at 10% p.a.
Fund Value at Maturity	Rs. 5,94,574	Rs. 7,43,261	Rs. 10,03,955	Rs. 14,12,382
Effective Return Rate	 3.13%	7.1%	 3.56%	 7.57%

I have added the last row of the above table myself, and the effective return rate is how much you are effectively getting if the fund performs at 6% or 10%. Since the amount above that is net of expenses – it is not actually based on 6% or 10% but is arrived at after deducting all the expenses.

So, in the first option you just get a return of 3.13% if the fund actually performs at 6%, and if the fund performs at 10% then you just get 7.1%, and in the 15 year term you get 3.56% and 7.57%.  I think this shows fairly significant expenses and an insurance of ten times annual premium doesn’t make these kind of expenses attractive enough.

Conclusion

Having reviewed this tells me that  ULIPs aren’t as bad as they once used to be and some people may actually find use for them if they want to boost their insurance coverage for example. But as far as I’m concerned, I don’t see any compelling reason to buy this policy, and I would much rather buy a term plan and make other investments according to whatever plan and preferences I have. That way I can buy whatever mutual fund I want instead of being limited to the ones offered through this plan and can also make changes mid way.

 

Google announced an unusual move today where they introduced a new class of shares that have no voting rights at all. Google already had two classes of shares – A shares that have one vote per share and B shares that have 10 votes per shares.

The founders own the bulk of the B shares and that gives them the ability to issue new stock without diluting their control over the company. The new class of shares they have issued is called the C class, and these shares won’t have any voting rights at all.

The way they are going to issue these new shares is to give a stock dividend of one C class share to each owner of a A class share, so everyone who owned one Google share will now own two shares – one class A and one class C.

Just like a regular split, or bonus issue – the stock price should drop by about half but in this case since the class C shares don’t have voting rights, they should trade at a lower price than the class A shares. Whether this will really happen or how deep the discount will be is anybody’s guess.

In an Indian context, this can be used to understand the concept of DVRs or Differential Voting Rights shares. Differential Voting Rights also mean that the owner of one class of share will have different voting rights from the owner of another class of shares.

Tata Motors is the most famous example of DVRs in India because it was the first one to issue DVRs, and it trades at a big discount to the Tata Motors ordinary share, something that it has done for quite some time. In the case of Tata Motors  – one DVR share has only one tenth the voting right of an ordinary share.

Currently, the Tata Motors DVR trades at Rs. 158, while the ordinary share trades at Rs. 285. The Financial Express had a story about this wide gap last year and how this was expected to close down, but for some reason this gap doesn’t seem to close.

The Tata Motors DVR also pays a higher rate of dividend than the ordinary share, and has a fairly good dividend yield as well.

These DVR type shares are a lot more common in the tech companies in the US than they are in India as Indian companies have probably not felt the need for protecting themselves against dilution of equity, and they’d much rather conserve cash than give it away in the form of higher dividends.

As far as retail investors are concerned, I don’t see how voting rights make much difference to them, and if you are the kind of person who likes to pick stocks and is looking for some stocks with good dividend yields that you can hold for long – the DVR space might offer some opportunities.

The topic of Futures and Options has come up quite frequently in comments and emails but I’ve never done a post on them till now because the posts got too long. I can remember deleting at least two drafts because they got too unwieldy, and complex.

I’ve tried to give it another shot, and simplify it by breaking it into parts. Here is the first part with some very basic and easily digestible information on futures and options.

Two Types of Derivatives

There are two types of Derivatives commonly traded in the market – Futures and Options, and within Options there is further a Call option and a Put option.

The price of these derivatives is based on an underlying asset, and the price of the derivative usually moves in tandem with the price of the underlying. The underlying is usually a stock or an index in the context of investing in a stock market.

So, that means the price of Infosys futures or Infosys options will depend on the price of the Infosys shares. But if that’s the case then why don’t people simply buy the stock or the index fund?

Why Buy Futures or Options?

While there are other reasons, I think two big reasons are leverage and taking short positions. Options and Futures give you a lot of leverage and you can make (or blow up) a large amount of money in a short period of time with the same amount of capital than you can with a regular cash position.

The second reason is to take short positions, or profit from declines in the price of a share or commodity. If you want to take a bet that a particular company will do badly, and then profit from it then you can’t do it very easily in the cash market.

But you can sell a future, call option or buy a put option to take a short position in the stock or index.

The third common reason I hear is hedging risk, and while I agree that it is a big reason for institutional investors, I just can’t see how retail investors can efficiently hedge with derivatives. The notional values of derivatives is often too high, and the expiry periods too short to act as an efficient hedge for small investors.

Who should buy Derivatives?

I think the big difference between buying derivatives and buying a share in the cash market is that your investment can go to zero a lot more frequently in the derivatives market than in the cash market, and only those people who have a high risk appetite and who can stomach losing a lot of money should invest in derivatives.

I think you should also be fairly clued in on the market to make these kind of leveraged bets, but if you asked me what “fairly clued in on the market” means I would find it very difficult to define that.

That being said, they can be quite profitable as well because they give you the ability to profit from short positions and add leverage.

I think the bottom line is that you should only invest that amount of money in derivatives that you are comfortable in losing. They aren’t for everyone, and not everyone should dabble in them.

I’ll stop this post here, and in the next part of this series build on what it means when  you say the price of a derivative depends on the underlying.

This post is from the Suggest a Topic page. 

• Part 1: Introduction to Futures and Options
• Part 2: How do Futures Work?
• Part 3: How do Options work?

Prat had an interesting question on how a share price is calculated on the stock exchange at any given point, and his question had more to do with the mechanics of share price calculation, and not on value or demand and supply etc. which is what is commonly talked about.

So, when you see that the price of Infosys is Rs. 2,850 – how was the price calculated at that given time?

The calculation of prices is completely automated, software driven, and anonymous at both BSE and NSE, and the price is calculated by electronically matching bids and offers for a particular share recorded an electronic limit order book (ELOB).

When you place an order to buy a share at a certain price that is called your “bid” and when you place an order to sell your shares at a certain price that’s called your “ask”.

The ELOB contains all the bid – asks for a particular share and the system matches the best bids and asks to execute an order. The price at which a transaction is executed is called the last traded price (LTP) and that’s what you see on TV screens.

From the NSE’s website – let’s take a look at an example ELOB to understand this process.

An example of an order book for a stock at a point in time is detailed below:

Buy			Sell
S.No.	Quantity	Price	Quantity	Price	S.No.
1	1,000	3.50	2,000	4.00	5
2	1,000	3.40	1,000	4.05	6
3	2,000	3.40	500	4.20	7
4	1,000	3.30	100	4.25	8

If you look at the above table, the left side are the bids and the right side are the asks. As it stands – there can’t be any transaction because the highest price that the buyers are willing to pay is lower than the lowest price at which the sellers are willing to sell. However, if you come in and put up a market order to buy 3,000 shares – your order will be executed and you will get 2,000 shares at Rs. 4.00 and the remaining 1,000 shares at Rs. 4.05.

Similarly if you wanted to sell 2,000 shares – the first 1,000 will be sold at Rs. 3.50 and the second thousand will be sold at Rs. 3.40.

The exchange gets you the best price that is available at that given time whether you are a buyer or seller and if you have placed limit orders then those orders will not be executed as long as someone matches that on the other side of the transaction.

At a high level, matching the bids and asks on a stock based on the volume at that time determines the stock price. I’m sure there are a lot of intricacies in this system, but I’m unable to write about them because I’m not familiar with them myself. If you have a link that goes deeper than this then please do leave a comment.

This post was from the Suggest a Topic page.

In part 1 of this series I wrote about the evolution of an investor to either a trader or a long term investor, and said that I favor long term investing to short term trading.

Then in the second part I wrote about the implicit assumption that a long term investor makes which is over a very long period of time the market will move upwards, and then also spoke about the nature of a share or stock. That nature I said was that a stock is a representation of the earnings of a company, and looking at it that way helps you stomach the volatility that exists in the market and deal with the daily ups and downs.

In this part I’m going to build on the two concepts I spoke about earlier and share a few thoughts on execution.

I invest regularly in the market throughout the year but I don’t have a SIP set up and I do this on my own. I invest very aggressively in the market when there is doom and gloom and put in as much as I can like I was doing last December, and during the Lehman crisis, and I slow down (but still keep investing) when there isn’t much doom and gloom but people are not over the top as well. The market right now resembles that situation and while I’m investing in the market the sums that go in the market aren’t as much as they were last December.

There are three big ideas behind this type of thinking – one is that in the long term I expect markets to edge upwards so even if they are down today I feel that they will be up 3, 4 or 5 years down the line and as long as no one forces me to sell the position – I can wait for the tide to turn and sell at that time.

The second big idea is that markets don’t move in a linear fashion, and no one knows when, why or by how much they will go up or down. You can’t simply stop investing with the fear that the market will go down more because there is no way to know when the tide will turn and by how much the market will rise then. If you sit on the sidelines when the market is down, then I’m pretty sure you’re sitting on the sidelines through most of the earnings that come about when the tide turns.

The past decade has shown us that up moves have been as violent as down – moves and that too at very unexpected times, so that’s why I like to stay invested in the market as much as I can. I hear a lot of people say that I’m going to start investing when the market turns and perhaps Santa whispers when the market is about to turn in their ears, but I am not one of those people.

Here is a chart that illustrates what I’m talking about.

 

The third big idea is that while you can’t time your in and out, you can try to calibrate how much you put in the market, and while that exposes you to additional risk – if you don’t have any loans and can stomach risk and volatility then it is possible to make this volatility work in your favor rather than give you jitters.

The big difficulty in doing this is it’s very hard to buy when everyone else is paring down and the general atmosphere is of doom and gloom. However, if you view a stock as ownership in a company (like I wrote in the earlier post) and if you believe that the company will survive the downturn – that gives you confidence to hold on and continue buying. Then when the tide turns you will be sitting on some good profits, and you won’t be rushed into investing in the market like the people who feel left behind by sudden market jumps, and the jumps are always sudden, so at that time you can moderate your investments.

I think people who are starting out can leave calibrating out of the equation and start with investing small sums monthly which they continue with even when the market is down. I say small sums because it doesn’t hurt as much when you see them in the red (which you inevitably will) and it makes it easier to continue investing small sums even when the market is falling. Within a three to five year period you will get a sense of where you stand as far as shares are concerned and whether you want to stay away completely from them (understandable) or want to go in very aggressively (also understandable) but whichever way you eventually turn to I’d recommend you follow this approach initially rather than buying and selling daily or weekly in an ad-hoc manner.

In the next part of this series I will write about some type of mutual funds that can be used to invest in equities regularly and execute this strategy.

• Part 1: How should beginners approach investing in the stock market?
• Part 2: How should beginners approach investing in the stock market?
• Part 3: How should beginners approach investing in the stock market?
• Part 4: How should beginners approach investing in the stock market?

Pradeep Sharma left a comment the other day about how he had set up a recurring deposit with ICICI Bank and how the final amount he was calculating was different from the amount that the ICICI Bank representative told him.

That difference was due to the fact that while he was compounding interest monthly, banks usually compound interest quarterly and that’s why he was getting a different answer.

Paresh responded to that comment telling him what caused the difference, and when I looked at the response, I thought I’d add to it by providing a link to how interest on recurring deposits (RDs) are calculated.

I was surprised to see that while there were quite a few recurring deposit calculators, there were hardly any explanations and the few that existed were really very short explanations on how interest on RD was calculated.

So, I decided to give it a try myself, and it took me an embarrassingly long time and several mistakes to do that even though the concept is very simple.

Understand Compound Interest To Understand Recurring Deposit Interest

When you create a RD for Rs. 10,000 for 2 years, what you’re doing is depositing Rs. 10,000 with the bank every month for 24 months, and the bank pays you interest on Rs. 10,000 for 2 years compounding it quarterly, then for the next Rs. 10,000 it pays you interest for 23 months, and so on and so forth.

Banks usually compound interest quarterly, so the first thing is to look at the formula for compound interest.

That formula is as follows:

A formula for calculating annual compound interest is

Where,

• A = final amount
• P = principal amount (initial investment)
• r = annual nominal interest rate (as a decimal, not in percentage)
• n = number of times the interest is compounded per year
• t = number of years

In your recurring deposit, you use this formula to calculate the final amount with each installment, and at the end of the installments, you add them all up to get the final amount.

Think of RD Installments and Series of Principal Payments

Let’s take a simple example to understand this – suppose you start a recurring deposit for Rs. 47,000 per month for 2 years at 8.25% compounded quarterly. If you were to see this number as a standalone fixed deposit that you set up every month for 24 months, you could come up with a table like I have here. Before you get to the table, here is a brief explanation on the columns.

• Month: First column is simply the Month.
• Principal (P): Second column is P or principal investment which is going to be the same for 24 months,
• Rate of Interest (r): r is going to 8.25% divided by 100.
• 1+r/n: In our case, n is 4 since the interest is compounded quarterly, and 1+r/n is rate divided by compounding periods.
• Months Remaining: This is simply how far away from 2 years you are because that’s how much time your money will grow for.
• Months expressed in year: I’ve created a column for Months expressed in a year since that makes it easy to do the calculation in Excel.
• nt: 4 multiplied by how many months are remaining as expressed in year.
• (1+r/n)^nt: Rate of interest raised by the compounding factor.
• Amount (A): Finally, this is the amount you if you plug in the numbers in a row in the compound interest formula.

So, Rs. 47000 compounded quarterly for 2 years at 8.25% will yield Rs. 55,338.51 after two years. The last row contains the grand total which is what the RD will yield at the end of the time period.

Month	P	r	1+r/n	Months remaining	Months expressed in year	nt	(1+r/n)^nt	A
1	47000	0.0825	1.020625	24	2	8.00	1.18	55338.51
2	47000	0.0825	1.020625	23	1.916666667	7.67	1.17	54963.21
3	47000	0.0825	1.020625	22	1.833333333	7.33	1.16	54590.45
4	47000	0.0825	1.020625	21	1.75	7.00	1.15	54220.22
5	47000	0.0825	1.020625	20	1.666666667	6.67	1.15	53852.50
6	47000	0.0825	1.020625	19	1.583333333	6.33	1.14	53487.27
7	47000	0.0825	1.020625	18	1.5	6.00	1.13	53124.53
8	47000	0.0825	1.020625	17	1.416666667	5.67	1.12	52764.24
9	47000	0.0825	1.020625	16	1.333333333	5.33	1.12	52406.39
10	47000	0.0825	1.020625	15	1.25	5.00	1.11	52050.97
11	47000	0.0825	1.020625	14	1.166666667	4.67	1.10	51697.97
12	47000	0.0825	1.020625	13	1.083333333	4.33	1.09	51347.35
13	47000	0.0825	1.020625	12	1	4.00	1.09	50999.12
14	47000	0.0825	1.020625	11	0.916666667	3.67	1.08	50653.24
15	47000	0.0825	1.020625	10	0.833333333	3.33	1.07	50309.72
16	47000	0.0825	1.020625	9	0.75	3.00	1.06	49968.52
17	47000	0.0825	1.020625	8	0.666666667	2.67	1.06	49629.63
18	47000	0.0825	1.020625	7	0.583333333	2.33	1.05	49293.05
19	47000	0.0825	1.020625	6	0.5	2.00	1.04	48958.74
20	47000	0.0825	1.020625	5	0.416666667	1.67	1.03	48626.71
21	47000	0.0825	1.020625	4	0.333333333	1.33	1.03	48296.92
22	47000	0.0825	1.020625	3	0.25	1.00	1.02	47969.38
23	47000	0.0825	1.020625	2	0.166666667	0.67	1.01	47644.05
24	47000	0.0825	1.020625	1	0.083333333	0.33	1.01	47320.93
							Final Amount	12,29,514

I’ll be the first one to admit that this is not a very intuitive way to either explain or understand recurring deposits calculation, but this is the only way I could write which seemed to convey the calculation comprehensively.

If you have any questions or have links to better ways to explain this then please leave a comment!