Leveraging the Power of Compounding

Leveraging the Power of Compounding

Compounding creates a snowball effect. Over time small amounts keep adding up to create a large corpus. The growth accelerates as time goes by and the corpus keeps getting larger. The key to leverage the power of compounding is to stay invested for a longer term. The longer your investment time frame, the more compounding works at an accelerated pace.

Let us look at an example to see how this works.

Rita invests a modest ₹4,000 each month in a mutual fund plan that earns her an average annual return of 13%. If Rita keeps investing this amount regularly for 30 years, her corpus at the end of the tenure will be ₹1.78 crore.

Now, say Rita changes her plan altering the 3 key variables: principal amount, rate of interest and time frame in each of them. Let us see how these changes affect her returns.

Option 1: Change in the rate of interest: Rita chooses a fund where she gets an annualised return of 11% 
Option 2: Change in the principal invested: Rita reduces her investment to ₹3,000 per month 
Option 3: Change in the time frame: Rita reduces the tenure to 25 years instead of 30 years

In Option 1, Rita will get ₹1.14 crore
In Option 2, Rita will get ₹1.34 crore 
in Option 3, Rita will get ₹91.8 lakh

Thus, you can see that reducing the interest rate or reducing the investment amount didn’t have so much an adverse impact as reducing the tenure from 30 years to 25 years. This shows the impact of a longer time frame and how compounding can impact your investments in the last 5 years.

The power of compounding helps you reap greater returns as over time the earnings from your investments are not spent but reinvested, earning greater returns. The gains from compounding appear modest towards the early period but gather strength as the years pass and the money stays invested longer.

Leveraging the Power of Compounding for Maximum Benefits.

Start Early

Let’s consider two friends Vivek and Rahul. Vivek started investing a small amount of ₹3,000 every month when he was 25 years old. Rahul chose to settle down first, so that he can invest larger amounts at a later stage. He started investing ₹12,000 at 45 years each month. Assuming both of them invested in the same equity diversified mutual fund giving them an annualised return of 12%, the final corpus of Rahul, when he turns 60, will be ₹61.2 lakh. Vivek’s corpus, on the other hand, will be ₹1.96 crore! So you can see that even though Vivek invested just ₹3,000, investing regularly and starting early gave him a huge advantage over Rahul. It earned him almost three times the amount as compared to his friend on retirement. Many young investors keep procrastinating thinking that they will compensate later in life by investing a larger amount to cover up for the lost time, without realising the lost opportunity to benefit from the extraordinary power of compounding.

Rate of Interest

Another factor that plays an important role in deciding the final corpus is the rate of interest your investment earns. If you opt for safety and invest only in debt instruments that give you an annualised interest of 8-9%, then your real rate of return is only 1-2%, if ongoing inflation is estimated at 7%. The returns actually become negative in case of fixed term deposits that give you an interest rate of 6-7%. Only equity investments, held with a long-term view and combined with power of compounding, have the potential to give the highest possible return, helping you beat inflation and build a substantial corpus. Long-term gains on equities are also tax-free, which makes it much more attractive as compared to other asset classes.

Lastly, avoiding withdrawals, starting early and investing regularly will ensure that your investments derive the maximum benefit from the power of compounding, an help you build a sizeable corpus.

Happy Investing

Source:hdfcmfinvestwise.com