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What Is Power Of Compounding And The Wonders It Does In Wealth Creation
Oct 31, 2017

No one understood and used the power of compounding better than Mr Benjamin Franklin. The noted American revolutionary, diplomat and inventor needs no introduction. Mr Franklin is also the one to advise: 'A penny saved is a penny earned'

Before he died in 1790, Mr Franklin bequeathed the cities of Boston and Philadelphia 1000 sterling ($2200 approx.) each. However, he put a few conditions. The interest was to augment the principal continually, and at the end of 100 years, 75% the fund was to be expended for "public works", and the balance was to be compounded for another hundred years. Mr Franklin had prescribed an annual rate of just 5%.

In 1990, when the cities received their balances after 200 years, the combined bequest had grown to $6.5 million!!

This is certainly a testament to the power of compounding - the very thing Ben Franklin counted on and wanted to demonstrate. Even Albert Einstein described compounding as 'The most powerful force in the universe'.

Well, one may not live to see their investments a hundred years later, but if invested wisely; their corpus can grow to a significant amount in a reasonable time frame.

How does compounding work?

With compound interest, the first year's interest is added to the principal. For the second year, therefore, the principal which is now earning interest is higher. The principal will be more the next year, still more the year after that, etc. Thus, each succeeding year's interest will be correspondingly greater than in past years.

Therefore, if you invested Rs 1 lakh today in an investment growing 10% annually compounded, after 20 years, the investment would be worth as much as Rs 6.73 lakh.

Here are three ways to make the best use of compounding:

  1. Start early - Longer the investment horizon, the betterAs seen in the above example, you were able to grow an investment of Rs 1 lakh to nearly Rs 7 lakh in 25 years, at a compounded rate of 10%. However, if you extended the investment horizon by another 5 years, the corpus would then be worth Rs 10.83 lakh. As you can see, the corpus grows faster as the investment grows. Likewise, the longer the time you have on hand, the lesser you will need to save each month and more you can gain from the compounding effect.The longer you invest, the magic of compounding will work in your favour and grow your wealth. This is one of the primary reasons why it is highly suggested that you should start saving early-on for retirement. By beginning early, you will be able to accumulate a much bigger retirement corpus.

  2. Invest wisely - Seek high return investment productsIf you invest in an Bank Fixed Deposit earning an interest rate of 7%, after 20 years Rs 1 lakh would grow to Rs 3.87 lakh. This is about half the corpus of the investment earning 10% per annum. If you were able to invest in a product that earned 14% p.a., the Rs 1 lakh investment would now be would worth a whopping Rs 13.74 lakh.Clearly, a small difference in interest rate can make a huger difference in returns over the long term.

  3. Grow your investment and invest regularlyWell, it's common sense that if you invest a higher amount, you will have a bigger corpus at the end of the investment horizon. However, this is one aspect of investing that is often not taken seriously. Many invest in an ad hoc manner. Even though their income and savings increase every year, their investment amount remains stagnant. But, regularly increasing your investment amount can make a huge difference over the long term.In addition, investing regularly will help you to take advantage of the volatility in the equity market. You will be able to average out your costs by buying more units when the market corrects.With SIPs, you imbibe a regular investment habit that can compound your wealth and enable it to grow leaps and bounds. If you had invested Rs 2.4 lakh two years ago, the total value of portfolio would be Rs 3,38,667. However, if invested Rs 10,000 every month, the total value of his portfolio value would be Rs 3,41,285.

One of the easiest ways to understand the effect of compounding on your investment is to use the 'Rule of 72'. The Rule of 72 helps you to calculate what rate of return it requires to double your money in a certain number of years. Alternatively, it can be used to show what number of years it will require to double your money at a particular given rate of return.

Rate of Return required to double your money = 72 / Number of years

If you are earning say 15% on an investment, you can expect your invested money to double in 72/15 years i.e. 4 years and 10 months. Similarly, if you want your investment to double in 6 years, the investment needs to grow at a compounded rate of 12% (72/6).

Remember however that the Rule of 72 is only a very broad approximation of the actual answer. To get a more accurate answer, use the number 69 instead of 72. The number 72 is used only because it is easily divisible by many numbers.

Over the long-term, equity mutual funds are effective in beating the inflation bug. Meaning, they hold the potential to clock a decent real rate of return (also known as the inflation-adjusted returns).

Unlike most fixed income products, the long-term gains (for a holding period over 12 months) earned on equity mutual funds are tax-free. Hence equity as an asset class is said to be tax efficient.

In addition to this, investors looking for tax-saving avenues can invest in Equity Linked Savings Schemes (ELSSs). Here, you can claim tax benefits under Section 80C of the Income Tax Act; the amount invested is eligible for deduction from the gross total income, subject to an upper limit of Rs 150,000 in one financial year. Investments in tax-saving funds are subject to a 3-year lock-in period.

On the other hand, the interest earned on a bank FD is taxable i.e. added to the total income and taxed as per the individual's tax slab.

Historically, inflation has been in the range of 6-7%. Based on historical prices, equities have given a return of 12%-18% and even averaged above 20% per annum during the period 1980 to 1996. Given that equities can deliver a return of 12-15% p.a., your equity portfolio will beat inflation, delivering a healthy 4%-7% post-tax, post-inflation, real return.

However, the key here is selecting best mutual fund schemes and having an investment time horizon of at least 5-7 years. Staying the course with good investments can make you richer.

You cannot ignore having equity mutual funds in your portfolio. At the same time, you need to be prudent when selecting a fund. Don't approach a distributor or a bank relationship manager to identify the top mutual funds. They will most likely suggest funds that earn them a higher commission.

So there are hundreds of equity funds, how do you pick the right ones for your portfolio? You need access to unbiased research-backed guidance that helps you select the best equity mutual fund schemes.

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This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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