Compounding: the magic in investing
Investing early in your career, getting the basics in place and inculcating discipline about money go a long way in making your money work for you.
Everyone is free to grow their wealth. For instance, if you invest just Rs2,000 each month from when you start earning and keep at it for 25 years, the final value of your investment would be about Rs20 lakh, assuming a return of 8% per annum. Your principal amount in this would be only about Rs6 lakh. The remaining Rs14 lakh would be the interest and interest on interest, in other words compounding. Just let the money remain invested and the magic of compounding does the rest.
Get time on your side
Compounding works on two features that you can structure into any investment in your portfolio. One is to give your investments the time to build momentum, and the second is to have the discipline to remain invested.
Start early and don’t wait to accumulate a large sum before you begin investing. If you started investing just Rs2,000 a month when you were 25 and continued till you were 60, the value of your corpus would be Rs46 lakh. However, if you waited till you were 35, and invested double that—Rs4,000 per month—till you were 60, your corpus would be much lower at Rs38 lakh.
Contribute to mandatory retirement schemes like the Employees’ Provident Fund (EPF) and the National Pension System (NPS) from the beginning. Not only does your employer match your contribution, but the money goes out of your pay cheque and you don’t get a chance to procrastinate. For the rest, most investments can be made with small amounts, whether it is mutual funds, government-guaranteed products like National Savings Certificate (NSC), Public Provident Fund (PPF) and other post office schemes or investing in securities on the stock markets. Understand the risks you are willing to take with your investment and your liquidity needs, and start investing with the money you are able to save each month. Get the hygiene factors in place: open a bank account, get your permanent account number (PAN) card and complete the know-your-customer formalities, so that you are set to go.
Let the money work for you
Clearly earmark the investments for long-term goals, so that there is no compulsion to draw from them in the interim. When you don’t withdraw and use the returns earned on investments, the base on which the next tranche of return is earned keeps expanding from one period to the next as the returns of the previous period gets added to the principal invested. This translates into higher earnings in each subsequent period, and this virtuous cycle builds a larger corpus over time. Over time, the contribution that compounding makes to the final value of your investments will be more than the amount you had invested. Build an emergency fund to meet unexpected and unplanned expenses. It will go a long way in protecting your investments from the risk of being withdrawn early.
You can use the in-built feature for re-investment that many investments provide, to allow the returns to compound over time. Bonds and deposits have the cumulative option that re-invests the interest you earn into the same investment. The maturity value will have the compounded returns over the period.
Have the discipline to re-invest the proceeds as soon as investments mature, so that there is no down time and your money keeps working for you. If you are investing through mutual funds, choose the growth option or dividend re-investment option to make sure that your returns remain invested and have a chance to compound. The benefits of compounding are magnified when the returns are higher, as in the case of long-term equity investing.
Another way to boost the impact of compounding is to make periodic, regular investments so that the base value on which the returns are earned increases not only from the gains that are ploughed back, but also from the additional investments. Have an investment plan to invest regularly and sign-up for automatic investment plans offered by products such as mutual funds for an easy way to execute this.
Other choices that you make can add to the benefits. Products that offer more frequent compounding, say, quarterly instead of annual, will see a higher final investment value. Choose options that allow tax deductions on the accumulated value of the investment at the end of the investment period over annual tax deductions. The investment value available to earn compounded returns is effectively lower to the extent of taxes paid annually.
The other side of compounding
Compounding works against you with the same intensity when you are paying interest costs instead of earning returns. Higher the interest cost and period of debt, greater will be additional interest burden from compounding. Think of credit card outstanding that compounds interest on a daily basis and you get the picture. It is important to pay off the higher-cost debt and limit the tenure of the loans you take.
We tend to brush aside compounding because it takes time to show its benefits. But once you understand how it works, make it an integral part of your investment strategy.