-By Ananya Sinha
Imagine two coworkers - A and P, both starting their careers at age 22. A decides to invest ₹3,000 every month in a mutual fund offering 10% annual returns, beginning right away. P by contrast delays her investment journey until age 32 but compensates by contributing 6,000 a month to the same fund.
Now that you are 59 years old and I have only just started out. So despite P investing twice the amount monthly A’s wealth far exceeds P’s! Why? Because there is an early start She has an advantage of 10 years for her investments to compound over time creating exponential growth over time.
So, are you curious to unlock the secrets behind this financial growth? Let us explore the power of compounding!
WHAT IS COMPOUNDING?
Compounding works on the principle of re-investing the profits made so that subsequent interests earned based on previously earned interest would be re-invested.
Consequently, money starts to make money making exponential growth. Thus through investment of a small sum of money on a constant basis, the interest amount could make the whole amount significantly higher over the passage of time for example, making the true statement "Time is money" in investments more likely. The crucial ingredient in compound return is time. It all becomes more noticeable when investment periods or periods for which a principal was invested are increased.
Consider an example invest ₹100,000 at an annual interest rate of 15% for 30 years. The future value can be calculated using the formula: 𝐹𝑉 = 𝑃 × ( 1 + 𝑟 ) t
Where:
FV = future value,
P = principal amount (₹100,000),
r = annual interest rate (0.15),
t = number of years (30).
Using this formula, the future value would be:
𝐹𝑉 = 100,000 × ( 1 + 0.15 ) 30 ≈ ₹66,216,000
This example clearly illustrates how starting with a relatively modest investment can yield millions over time due to compounding interest.
THE POWER OF COMPOUNDING
In the example below, "Alma" invests $10,000 when she's 31 and lets the money grow for 20 years. "Dave" invests $2,000 a year on the same day each year, starting at age 41, for only 10 years. By the time they both reach 50, Alma has nearly 15% more than Dave even though she invested half as much.
Source: Schwab Centre for Financial Research.
The chart above is hypothetical and for illustrative purposes only. Returns assume reinvestment of dividends and capital appreciation. Fees and expenses would lower returns. Earnings assume a 6% annual rate of return and do not reflect the effect of fees or taxes which would reduce the overall amount.
ADVICE FOR PITFALLS: DISCIPLINE AND PATIENCE
Market Volatilities Impact of Staying Invested During Market Volatilities.
Resilience of Markets: Historical data shows that markets recover and grow long-term, making investing crucial to capitalize on rebounds.
Compounding Returns: Remaining invested during downturns ensures benefiting from subsequent recoveries avoiding the loss of potential gains from compounding.
Avoiding Emotional Decisions: A disciplined investment approach prevents fear-driven sell-offs during market dips from causing unnecessary emotional damage, reducing the risk of poor outcomes.
Historical Trends: While volatility is present long-term investing yields favorable returns e.g. U.S. Stocks have averaged 10% annual returns since 1926.
Dangers of Early Withdrawals
Disruption of Compounding: Early withdrawals reduce the principal balance, curtailing potential returns and wealth building.
Retirement accounts often impose penalties and taxes for withdrawals early, reducing overall savings.
Withdrawing early undermines long-term goals like retirement savings where extended compounding is vital for financial security.
To maximize compounding benefits staying invested during volatility and avoiding early withdrawals are essential to maximize the compounding benefit, meet financial goals, and secure a stable financial future.
INVESTMENT VEHICLES FOR COMPOUNDING
Mutual funds are investment instruments that pool funds from numerous investors to acquire a diversified portfolio of stocks bonds or other securities. By leveraging the expertise of professional fund managers mutual funds provide a way for individuals to invest across various asset classes without a vast knowledge of the financial markets. This diversification reduces risk and can improve potential returns over time through the power of compounding.
The Public Provident Fund (PPF) is a long-term savings scheme backed by the Government of India whose objective is to encourage saving among citizens. It offers an attractive interest rate that compounds annually and is favorable for a low investor. Contributions to a PPF account offer tax benefits making it an effective tool for wealth accumulation over 15 years.
Bonds are fixed-income securities and represent a loan made by an investor to a borrower usually corporate or governmental. Investors in bonds earn interest at regular intervals and the principal amount is returned to maturity. Various types of bonds, such as government bonds municipal bonds, and corporate bonds, differ in terms of risk and expected returns. Bonds also benefit from compounding by reinvesting from interest payments, aiding wealth growth.
Investing in Stocks allows individuals to purchase equity in companies or to buy dividends in exchange for cash. This can potentially lead to significant capital gains over time. Stocks can provide dividends in addition to price appreciation and reinvesting these dividends can enhance the compounding effect.
HISTORICAL EXAMPLES IN THE INDIAN MARKET
Reliance Industries: As one of India's leading conglomerates Reliance Industries has shown considerable growth in its stock price over the years. In 1995, if an investor had bought 10,000 Reliance shares, their investment would have grown to over 8 lakh by 2023 assuming an annual growth rate of close to 15%. This substantial growth exemplifies the reinvestment and long-term holding compounding effect.
HDFC Bank: Known for its strong fundamentals HDFC Bank's stock has appreciated significantly. An initial investment of 10,000 in HDFC Bank shares around its 1995 IPO would be worth over 1.5 lakh today. This would be the power of compounded annual growth averaged around 18% during this period.
Mahindra & Mahindra: This company consistently has provided good returns to its investors. An investor who has invested 5,000 per month in Mahindra shares over the last ten years could have substantial wealth if the total investment amounts to about 12%-14% in recent years. Overall the corpus to reach 9 lakh will show compounding effects effectively.
MUTUAL FUNDS IN INDIA
Several mutual funds operating in India have shown the efficacy of compounding which allows investors to grow their wealth steadily over time.
SBI Bluechip Fund: This fund focuses on large-cap companies and has provided returns averaging around 13% annually over the past decade. If an investor had consistently invested 5,000 every month they could accumulate a corpus of approximately 11 lakh over 10 years.
ICICI Prudential Small Cap Fund: With an average annual return of approximately 14% this fund combines investments in both market-cap and stock-consolid Regular investments via SIPs in this fund illustrate how compounding leads to wealth creation as the total investment could grow to 15 lakh over 10 years.
Kotak Standard Multicap Fund: This fund has shown robust performance with an annual return of about 12% to 15%. A total investment of 25,000 per month for 10 years would grow to about 10 lakh, benefiting extensively from the compounding phenomenon.
Notable Indian Stocks Demonstrating Compounding. Certain individual stocks listed on Indian exchanges have also illustrated the power of compounding such as :
IT leaders like Infosys have delivered incredible long-term returns. An investment of 5,000 under consideration during its 1993 IPO would now be worth well over 30 lakh in the United States due to the substantial compounded returns accrued over decades.
Asian Paints: The leading paints manufacturer in India has shown consistent growth. In 2002 a project of 1 lakh would be worth more than 3.5 lakh today assuming an annual growth rate of about 18%.
CONCLUSION.
The Power of Compounding rewards patience, consistency, and discipline and turns small investments into substantial wealth over time. Starting early and staying invested allows your money to grow exponentially by reinvesting both the principal and the return on invested funds. Market volatility should be viewed as an opportunity as staying invested ensures you benefit from a recovery. Investment options like bonds, mutual funds, PPFs and shares, cater to various financial goals and risk appetites. Avoiding early withdrawals safeguards the compounding cycle, thereby maximizing long-term returns. Compounding can help build a secure and prosperous financial future with a disciplined approach and a focus on the future.
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