You are about to invest in a three-year corporate deposit that pays 12.5% per year. Your representative informs you that if you do not withdraw the money on a regular basis and allow it to build until maturity, you will really receive a greater pre-tax yield of 13.1%. The difference is the additional returns you receive by allowing your money to be reinvested rather than receiving interest income and using it. That is the result of compounding.
Compounding simply increases the value of a little investment over time. That’s why it appears magical. How do you effectively use the power of compounding to grow wealth?
Compounding works best when you start early, give it sufficient time to work and most importantly apply it to an asset class that has potential to generate high returns.
Early bird gets it all
Consider the power of compounding when you begin early. Assume Anant begins investing Rs 50,000 per year at the age of 26 and receives a 12% annual return. He discontinues the yearly investment after 10 years, but leaves the corpus to grow and hopes to withdraw the money at the age of 55.
Udit, on the other hand, begins investing at the age of 36. That is immediately following Anant’s withdrawal of his investment. Udit meticulously invests Rs 50,000 per year for the next 20 years, till he reaches the age of 55. He, too, was able to earn a 12% annual return. How much do you believe they’ve accumulated now? Anant invested Rs 5 lakh over a ten-year period and received Rs 95 lakh. That’s a 19-fold increase! Udit ended up with approximately Rs 40 lakh, a fourfold increase over his initial investment of Rs 10 lakh. Anant has allowed compounding to work for him simply by starting early and sticking with it for a long time, despite discontinuing his contribution after ten years.
Applying it to asset allocation
If compounding can perform this feat, why not apply it to different asset classes to ensure optimal returns? We’re referring to your asset allocation. Assume Veena is a conscientious investor. She invests Rs 5000 per month, Rs 1000 in an equities fund and the rest in a recurring deposit, and has done so for the past 20 years. Her money grows to Rs 33.4 lakh from her total savings of Rs 12 lakh, as seen in the table. A substantial sum, assisted by compounding.
However, notice how much more she may get out of the same Rs 5000 each month by adjusting her asset allocation to stock and debt. Equity, as a superior long-term asset class, has delivered more with increased exposure, supported by compounding.
If you are a long-term investor, choose the appropriate allocation in different asset classes to allow the power of compounding to perform optimally for you. All of this, combined with starting to save early, will put you on the path to riches.