The importance of saving can’t be stressed enough during the times of the pandemic. We have heard of many stories of people losing jobs, having pay cuts / loss of income and hence struggling to meet their daily expenses.
Many people have run into huge medical expenses for treatment of COVID and have had to resort to loans or liquidation of assets to meet the same.
Compounding is one of the most important concepts in savings and investments.
“Compounding is the magic of investing,” said Jim Rogers, the famous American investor. According to Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Compounding is one of the most powerful tools in an investor's arsenal. The concept is simple to understand and its impact profound.
Mathematically speaking, compounding is defined as, ‘the increase in the value of an investment, due to the interest earned on the principal, as well as the accumulated interest.’
Simply put, it is a strategy that makes your money work for you while you are sleeping and help you create and grow your wealth.
It can be used to plan for your future goals, such as retirement, higher education of children, marriage of siblings / children, overseas holidays etc.
Simple interest means you earn interest on your principal. But with compound interest, you earn interest on the principal amount as well as interest on interest.
The appreciation in value terms over the invested amount is called as returns. The returns if calculated in percentage terms is the return rate (Return on Investment).
RoI generated over a time period of more than a year is called the compounded annual growth rate (CAGR). This formula has been taught to us in school, but rarely used in real life by many.
The following table compares the returns between simple interest and compound interest. You would notice the gap keeps rising as the tenure of investment keeps increasing.
To explain how this works through investment let’s look at an example.
If one invests Rs. 15,000 per month for 30 years and earns 8% per annum (p.a.), the corpus generated would be Rs. 2.2 crores at the end of the period. The corpus generated is more than four times the amount invested of Rs. 54.15 lakhs. This can be calculated in MS Excel using the future value (FV) formula. “FV(8%/12,30*12,-15000,0,0)”.
Scenario 1 Calculations: Source:
In the above example, if one starts late and wants to generate the same corpus within 15 years, then he / she has to invest double the amount (Rs. 30,000 per month) as well as earn double the interest (of 16%). This high interest rate is practically impossible in the current low interest rate scenario.
Scenario 2 Calculations: Source:
To generate the same corpus of Rs. 2.27 crores in 15 years, one has to invest Rs. 64,500 per month, more than four times the investment required if he/she started investing 15 years earlier.
Scenario 3 Calculations: Source:
Consistency and patience are very important in investing. It takes years to create wealth.
One does not need to earn high returns to generate a corpus. The earlier one starts investing, the smaller is the contribution and even with lesser returns bigger corpus can be generated.
Starting early provides more window of opportunity in different investment options which may not happen in a shorter time period. The ability to make amends in terms of contribution, returns in case of extraneous factors is possible when you start early.
If one starts early and there are some periods where the returns are lower or the individual is unable to maintain the contribution, then one could make amends in terms of higher contribution later or invest in alternative assets where returns are higher.
Another advantage of starting early and saving in a disciplined manner is that the amount may appear to be high as a proportion of income, but as time progresses and income increases, the contribution becomes easily manageable.
In the beginning, the task may look daunting, especially when the invested amount seems to be just a fraction of the corpus. Annual investments of Rs. 1.8 lakh is less than 1% of corpus of Rs 2.2 crores in the above example.
Many investors start investing late and then look for quick returns. But in the attempt to earn a fast buck, they sometimes make mistakes, take higher / unnecessary risks, resulting in big losses. The power of compounding magnifies over time.
The emotional stress and tightening of the purse can be avoided if one starts early.
Hence, it is better to have a long-term approach towards investing. Wealth is not generated overnight. One must invest patiently, consistently and in a disciplined manner to reap healthy returns and create wealth over time to meet financial goals.
Many times we find that certain investment products are introduced for a short period of time. For example, Tax free bonds were introduced in the early part of the last decade yielding 8.8%-8.9% CAGR with a tenor of 15-20 years. If one has a longer investment horizon, then he/she can capitalize on such less risky opportunities.
Another benefit of the power of compounding is that it protects our savings / investments against inflation. Inflation is also impacting our expenses on a compounded basis. So if the returns on our investments do not get compounded, our purchasing power gets eroded steadily.
The sooner we realise the benefit of compounding in life the faster we will be financially healthy.