Investments and the power of compounding.

We are all familiar with the concept of compound interest and the compound interest formula that we learned in our early school days. But what most of us do not appreciate is the extent to which the power of compounding or the magic of compounding works in our favour when we invest in equities. What is this compound effect and how does it really impact our investments?

If you identify quality equity assets and hold on to them with patience for the long term, you are bound to generate wealth. Why it is that equity generates wealth over the long run? The answer substantially lies in the power of compounding. When you invest in an asset, the investment earns returns. If you also reinvest these returns into the same asset, then these returns will earn further returns. When your investment and your returns are earning cumulative returns each year, it is called the power compounding. It is the cumulative effect of this power of compounding that helps equities create wealth.

 

How Mr. X compounded his money better despite the lower outlay

Let us consider the illustration of two friends Mr. X and Mr. Y who started investing via SIP in the same equity fund. X started early at the age of 25 while Y had a smarter plan. He decided to postpone his SIP by a few years and compensate by investing a larger amount later on. What could be the outcome? The results are captured in the table below. By the age of 45, both X and Y have contributed the same sum of Rs.24 lakhs to the ABC fund. But the wealth created by X is nearly 3 times the wealth created by Y. Why is that so? The answer lies in the power of compounding. By starting early (albeit with a smaller monthly outlay), X has allowed the money to compound for a longer period of time. While X’s investments compounded for 20 years, Y’s investments compounded only for 10 years. That made all the difference.

 

Case of X

Particulars

Case of Y

Particulars

Investment Avenue

ABC Mutual Fund

Investment Avenue

ABC Mutual Fund

Monthly SIP

Rs.10,000/-

Monthly SIP

Rs.20,000/-

Tenure

20 years

Tenure

10 years

CAGR Returns

15%

CAGR Returns

15%

Starts at the age of

25 years

Starts at the age of

35 years

Ends at the age of

45 years

Ends at the age of

45 years

Total Investment

Rs.24,00,000

Total Investment

Rs.24,00,000

 

 

 

 

MF value at age 45

Rs.1.52 crore

MF value at age 45

Rs.55.73 lakhs

 

Why are we blaming it on the power of compounding?

Essentially, the difference is all about compounding. The first Rs.10,000 invested by X has compounded for 20 years whereas the first Rs.10,000 invested by Y has only compounded for 10 years. When returns compound, the corpus, and the returns earn higher returns for a longer period of time. That is why, although Y doubled the SIP, his wealth is just about 1/3rd of X. In fact, Y would have to invest Rs.40,000/- per month over 10 years to reach the same level as X at the age of 45. That is the difference that compounding makes. The rate of compounding and the time period matter to compounding but time matters a lot more.

 

Moral of the story; follow X and make compounding work for you

While Y started too late, X made the power of compounding work better. It is not the amount of investment but the length of investment that really matters to compounding. Here are some thumb rules.

 

• When you have to invest; as well start early. That is because the earlier you start, the longer you earn returns and the longer your returns earn additional returns. Even if you start small it is ok but starting early is of paramount importance!

 

• Long term wealth is created by equity-related risk assets. A liquid fund grows at 4% per annum (net of tax) and will take 18 years to just double your money. It is only equities that give you the full benefit of compounding and create wealth over the long term.

 

• Very important, don’t disturb the flow of your wealth accumulation. Power of compounding works best when you do not indulge in intermittent withdrawals. If you are invested in mutual funds then dividend plans are best avoided. That will defeat the purpose of building wealth over the longer term. Your mutual fund SIPs and your demat account are not like your bank ATM.

 

• A good equity investment is one that beats the benchmark index like the Nifty or the Sensex. Therefore, you must constantly benchmark investment performance against the benchmark index. Occasional underperformance is understandable but if your stock or fund is consistently underperforming the index over a longer period of time, then power of compounding is unlikely to work in your favour. It is time for a switch!

 

The power of compounding forms the basis of long term investing and financial planning. Between your limited means and your unlimited dreams, there is one feature that can boost your investment value. That is the power of compounding!