>> POWER OF COMPOUNDING
Compounding
A rupee saved is millions earned
How compounding can make you rich!
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>> POWER OF COMPOUNDING
Dear Investor,
The focus of this month’s
s article is the power of
compounding and how it’s
s relevant to your long term
wealth creation. Please do feel free to write back to us
with queries or comments!
“The Power of Compounding” is an oft discussed topic in
today’s investment community. Although understood in
principle by most, the number of people actually
benefitting from its effects are far and few. We’ll explore
the two main reasons for this trend towards the end of the
article.
Albert Einstein said this about compounding –
“Compound interest is the ninth
h wonder of the world.
He who understands it, earns it ... he who doesn't ...
pays it.” He also went on to describe compound interest
as the “greatest mathematical discovery of all time”.
Why would Mr. Einstein
tein shower such praise on what
appears to be a relatively simple concept?
This is best illustrated with a hypothetical example. Let’s
assume for a moment that one of your ancestors worked
really hard and managed to generate a princely surplus of
Rs. 100 in
n the year 1813 (200 years ago). Being a wise
man, he chose not to splurge this money but to rather put
it away in a security that would perpetually give the bearer
of the security an annual interest of 9%. Over the next
couple of centuries, he and his descendants
cendants would enjoy a
return of Rs. 9 per annum or a total return of Rs. 1,800 –
not bad for an investment of Rs. 100! This is an example
of “Simple Interest”.
However, let’s assume now that your wise ancestor chose
NOT to withdraw the 9% annual interest but instead, to
plough it right back every year into his savings pool - year
on year. How much do you think the Rs. 100 would be
worth in 2013?
13? Rs. 1 Lac? Rs. 10 Lac? Rs. 50 Lac?
Wrong!
The value of this Rs. 100 in 2013 would be an eye
popping Rs. 3,05,70,29,208 or Rs. 305.7 Crores - enough
to sustain his family comfortably for many generations to
come!
Although this is an extreme example as the time period
assumed is unusually long, the same principle essentially
applies when you save small sums of money
systematically over long timeframes ranging from 10
years to 30 years or more.
Let’s consider two examples that are closer to reality –
savings for our kid’s education and for our own retirement.
retire
Imagine that you’ve been blessed with a baby girl a few
days ago, and you expect to incur an education cost of Rs.
20 Lacs when
en she turns 18 in the year 2031.
2031 Factoring in
a 10% annualized return (a fairly conservative estimate for
a high quality equity mutual fund SIP), you’ll need to put
away a paltry Rs. 3,330 per month from today till 2031 to
save up this amount. That translates into an ‘out of pocket’
savings of just Rs. 7.19 Lacs – and a cool profit
component of close to Rs. 13 Lacs! In another
anoth words, the
‘multiplier effect’ of compounding in this case is 2.78
times.
However, let’s for a moment assume
assu
that you chose to put
off your decision to save for her education and decided to
start saving for her higher studies when she turned 13
instead (with 5 years still to go).
go) The monthly savings
required in this scenario would be a hefty Rs. 25,800
25,
(albeit for a much shorter period of time). This translates
into an out of pocket savings of Rs. 15.49 Lacs and a notnot
so- exciting profit component of Rs.
Rs 4.5 Lacs. In other
words, you’ll need to save DOUBLE the amount to
accumulate the requisite 20 lacs by the year 2031, as the
multiplier effect drops to just 1.29 times in this case!
case
Let’s look at another example – your own retirement. If
you’re 30 years old today and would like to retire
comfortably with Rs. 5 Crores in the bank when you turn
60 – you need to put away Rs. 22,119 per month
systematically in a 10% return asset class,
class till the day you
retire.. While you may balk at this amount as it sounds like
li
a sizeable chunk of money today, what you need to note
here is that you’ll actually be saving just Rs. 79.62 Lacs
from your own pocket over the 30 year timeframe – the
remaining 4.20 Crores is pure profit from compounding! In
other words, the ‘multiplierr effect’ is a whopping 6.28
TIMES in this case, as the time horizon is longer than the
first example (30 years versus 18 years).
What‘s important to know is that a compounding
compoundi
graph
isn’t a straight-line one. In fact, for the first few years,
there’s very little to separate the magnitude of profits
earned from simple interest and compound interest,
respectively.
“Whoa! My great-great- great grandson’s a zillionaire!”
When it comes to compounding, longer timeframes mean
higher profits - and the real moolah starts pouring in only
after 10 years or more.
ore. In other words, the maximum
benefits of compounding are reaped if you can continue
saving for OVER 10 years. To illustrate - in the above
example of Rs. 22,119 per month, the fund value would be
Rs. 45 Lacs after 10 years and Rs. 1.67 Crores after 20
years. Your fund grows by Rs. 1.20 Crores between
year 10 and 20 – an exponential growth compared to the
returns received in the first 10 years. The chief reason for
this is that a compounding graphs looks somewhat like
this:
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>> POWER OF COMPOUNDING
What is even more unfortunate is when clients themselves
them
request their entire portfolios to be re-aligned
re
or
‘restructured’ - or decide to exit their savings plans based
on a year or two of ‘lower than expected’ returns!
returns This has
been especially true for SIP’s in the recent years. While
SIP’s derive maximum benefit from the ups and downs of
the market, many clients tend to terminate their SIP’s
when markets fall significantly, only to re-enter
re
them when
the markets approach
ch their peak. Illogical as it may sound
– this is exactly the kind of emotion driven mistake that
prevent a large number of ‘savers’ from getting wealthy in
the long run.
It would be wise to spend time selecting the best possible
savings tools with long term
erm track records, and then
sticking to them resolutely unless absolutely necessary.
Churning your funds too often would be akin to taking two
steps forward and one step back!
Compounding Killer #2: Choosing only low return
investments
Compounding Graph
Notice how
w the two curves (simple and compound interest)
move more or less hand in hand for the ffirst few years,
However, there’ss an ‘inflection point’ a few years down the
line when the two curves start digressing from each other,
and the gap between the two widens at an exponential
pace year on year for the next few years. The longer you
keep saving past this critical ‘inflection point’
point’- the richer
you’ll get from your savings. It’s as simple as that!
One can think of compounding as a snowball rolling down
a hill – the longer the snowball rolls (or the higher up the
mountain you begin), the more compounding will expand
the size of your snowball. Expanding your investment
portfolio through compounding should be your major goal
goal.
Given that compounding is really quite a simple concept,
why don’t we see a larger segment of the investment
community getting wealthy off their savings? There are
two primary reasons behind this trend, and we hope you’ll
avoid them:
Compounding Killer #1: Churn and Burn
Burn!
Moving in and out of
investments frequently (or
redeeming
your
funds
partially or fully now and
then) is a sure
sure-fire way to
ensure that you do NOT
benefit from compounding!
Unethical practices from distributors to maximize
commissions (since first year commissions on m
most
investments tend to be significantly higher than the
subsequent years) have often led to clients being ‘advised’
to regularly churn their portfolios, to their unfortunate
detriment. While a periodic review and subsequent ‘minor
tweaks’ to the broad asset
et allocation may be warranted
under certain conditions, switching between funds often
and for no apparent reason will most certainly nullify your
chances of earning compounded returns over the long
term!
The choppy markets and
uncertain global economic
environment have led to
more and more people
shying away from higher
yielding savings tools.
tools
More and more people are now concentrating their
ENTIRE savings into traditional tools such as Recurring
Fixed Deposits (RD’s) or Life
fe Insurance. This strategy is
equivalent to pushing the aforementioned snowball
over the sidewalk, rather than down a long, steep hill!
hill
While both RD’s and Endowment Assurance should form
a PART of one’s systematic savings plan, solely restricting
yourself to savings tools that earn you 6-8%
6
post tax
returns will rob you of the famed ‘multiplier effect’ of
compounding that we discussed previously. Check out the
table below:
End of Year
5%
10%
15%
20%
1
Rs.105
Rs.110
Rs.115
Rs.120
5
Rs.128
Rs.161
Rs.201
Rs.249
10
Rs.163
Rs.259
Rs.405
Rs.619
15
Rs.208
Rs.418
Rs.814
Rs.1541
25
Rs.339
Rs.1,083
Rs.3,292
Rs.9,540
Illustration: What. 100 would compound to under different
timeframes and return scenarios
Reverting to our previous retirement planning example – if
we were to save the requisite Rs. 22,119 in a savings plan
that yielded 8% per annum instead of 10%, our final fund
value on our retirement date would be Rs. 3.29 Crores
instead of Rs. 5 Crores. In other words, a seemingly small
return difference of just 2% would contribute to a massive
fund value difference of Rs. 1.71 Crores!
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>> POWER OF COMPOUNDING
The key lesson here is that for our long term savings, we
should aim to balance risk and reward adequately rather
than restricting
tricting ourselves purely to low return investments.
The long time horizon associated with most goal oriented
savings plans will absorb a large part of tthe risks of most
volatile investments (such as equities) in any case!
In order to reap the rewards of ccompounding and
dramatically expand your investment portfolio, a
systematic, disciplined approach to investing needs to be
followed. A system that more likely than not has a 20 year
horizon rather than 20 days. Now go start saving those
small amounts and lett compounding do its magic
magic!
Still confused about the effect of compounding on
your savings? We’ll be happy to help you out. Please
feel free to write to us at servicedesk@finedge.in or
call us on 011-4507
4507 2800. Good luck & Happy
Investing!
The author is Director & Business
Head at FinEdge Advisory Private
Limited. He can be reached on
aniruddha.bose@finedge.in
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