You are about to put your money in a three-year corporate deposit that offers 12.5 per cent a year. Your agent tells you that you will actually enjoy a higher pre-tax yield of 13.1 per cent if you don’t take out the interest periodically and accumulate it till maturity. The difference is the extra returns you make by allowing your money to be reinvested, instead of receiving the interest income and spending. That comes from compounding.
Compounding simply makes a small amount of investment larger over time. That is why it seems magical. How do you harness the power of compounding to build wealth efficiently?
Compounding works best when you start early, give it sufficient time to work and most importantly apply it to an asset class that has potential to generate high returns.
Early bird gets it all
Let’s look at the magic of compounding, when you start early. Suppose Anant starts investing Rs 50,000 a year from the age of 26 and earns 12 per cent a year on the investment. He stops the yearly investment 10 years hence but allows the corpus to grow and hopes to take out the money at the age of 55.
His friend Udit, on the other hand, starts investments at the age of 36. That is just after Anant stops his investment. Udit diligently invests Rs 50,000 a year for a good 20 years till he turned 55. He too managed to get a 12 per cent return every year. Now how much do you think they accumulated? Anant invested Rs 5 lakh in all for 10 years and received Rs 95 lakh. That’s a 19-fold jump! Udit ended up with about Rs 40 lakh, just a four-fold increase from his total investment of Rs 10 lakh. Merely by starting early, and holding on for long, Anant has allowed compounding to work for him, despite stopping his contribution after 10 years.
Applying it to asset allocation
If compounding can do this magic for you, should you not apply it to different asset classes to ensure optimal returns? We are talking of your asset allocation. Just suppose that Veena is a disciplined investor. She invests Rs 5000 a month – Rs 1000 in an equity fund and the rest in a recurring deposit and continues this habit for 20 years. As provided in the table her money swells to Rs 33.4 lakh from her total savings of Rs 12 lakh. A good sum; aided by compounding.
But see how much more she can manage with the same Rs 5000 a month by tweaking her asset allocation to equity and debt. Equity, being a superior asset class in the long term, has delivered more with more allocation, aided by compounding.
If you are a long term investor, then choose the right proportion of allocation in different asset classes to enable the compounding tool to work best for you. All this together with starting to save early will help you take the sure road to riches.