Thursday, March 15, 2012

Check the power of compounding

You must have heard this ad nauseam that disciplined investing and a long-term perspective hold rich rewards for the patient investor. Not convinced? Try answering this quick riddle. If a person saves 5,000 a month in an investment that earns 12%, his corpus at the end of 30 years will be 1.52 crore. Now, if he changes his plan and:
a. chooses an option that earns 9% annualised returns 
b. reduces investment to 3,000 a month 
c. reduces tenure to 25 years  
The question is, in which of the three options will his corpus be the lowest?
The correct answer is C, wherein his corpus would be 84.31 lakh compared to 85.1 lakh with option A and 91.56 lakh with option B. Reducing returns by 3 percentage points or the investment amount by 40% did not have as much a bearing on the final amount as the reduction of the tenure from 30 to 25 years. The last five years were crucial for the power of compounding.
The gains from compounding are initially modest but they gather strength as the years pass. The longer the money stays invested, the faster it grows. As the graphic shows, a 25-year-old person saving a modest 2,000 will have a corpus three times bigger than someone who starts saving four times as much at age 45.
The importance of an early start cannot be stressed enough. Here are some eye-popping statistics that illustrate how crucial the first 5-10 years are. What the 25-year-old investor puts away in the first five years will account for 44% of his total corpus at 60. His investments in the next five years will account for 25% of his wealth. The investments in the remaining 25 years will account for the balance 31% of the corpus. In other words, even if he stops adding to his investments after 10 years (when he is 35 years old), his corpus would grow to 75.33 lakh by the time he is 60. In stark contrast, the 45-year-old investor would have invested four times the amount for 15 years and would still have a corpus half the size.
Many young people keep procrastinating their investment plans. They should know that with each passing year, they are foregoing the opportunity to benefit from the extraordinary power of compounding. The best way to ensure financial nirvana is to start saving today. The amount you can save is not as important as getting started early.
What is crucial here is the discipline of not dipping into the corpus before you reach the financial goal. Do not withdraw from your investment because it would dilute the effect of compounding. Many investors make the mistake of choosing the dividend option of a fund when they are actually saving for a long term goal. Go for the dividend option only if you require the periodic payouts.
It's also important to continue investing regularly. The systematic investment plans (SIPs) offered by mutual funds ensure that a fixed amount flows into your investment kitty every month. Automate the process by setting up an ECS (electronic clearing service) with your bank. This will ensure that even if you forget to invest in a particularly busy month, your bank won't .

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