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Updated: August 7, 2010 14:51 IST

Fiscally Fit: Make compounding work for you

Shyam P.
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The columnist answers readers' queries on matters financial…

If there were one thing in finance that I need to learn, what would it be? How can I use it to achieve my financial goals? - Chandan Agarwal

According to the legendary investor Charlie Munger, understanding the power of compound interest and the difficulty of getting it is the heart and soul of understanding finance. There's an urban legend that Albert Einstein once said compounding is the most powerful force in the universe. What else can help you turn a few thousands into millions? The great thing about compounding is that it helps you achieve your long-term financial commitments, retire comfortably, and maybe even become rich beyond your wildest dreams.

At its most basic level, compounding is all about gains producing more gains. A rupee invested at a 10 per cent return will be worth Rs. 1.1 in a year. Invest this to get 10 per cent again, and you'll end up with Rs. 1.21 two years from your original investment. The first year earned you only Rs. 0.1, but the second year generated Rs. 0.11. Increase the amounts and the time involved, and you can multiply your wealth by just sitting idle.

For those who have forgotten their junior school mathematics, compound interest can be calculated using the following formula: FV = PV (1 + r) ˆ n. FV = Future Value (the amount you will have in the future); PV= Present Value (the amount you have today); r= Rate per year (your rate of return or interest rate earned); ˆˆ= Raised to the power of; n= Number of Years (the length of time you invest).

For interest rates less than 50 per cent, a simple way to know the approximate time it takes for money to double is to use the rule of 72. For example, if you wanted to know how many years it would take for an investment earning 12 per cent to double, simply divide 72 by 12, and the answer would be approximately six years. The reverse is also true. If you wanted to know what interest rate you would have to earn to double your money in five years, then divide 72 by five, and the answer is about 15 per cent.

Key concepts

Let's consider the case of two investors, Chetan and Abhishek, who'd like to become crorepatis. Say Chetan put Rs. 20,000 per year into the market between the ages of 24 and 30, that he earned a 12 per cent after-tax return, and that he continued to earn 12 per cent per year until he retired at age 65. Abhishek also put in Rs. 20,000 per year, earned the same return, but waited until he was 30 to start and continued to invest Rs. 20,000 per year until he retired at age 65. In the end, both would end up with about Rs. 1 crore. However, Chetan had to invest only Rs. 1,20,000 (i.e. Rs. 20,000 for six years), while Abhishek had to invest Rs. 7,20,000 (Rs. 20,000 for 36 years) or six times the amount that Chetan invested, just for waiting only six years to start investing. Clearly, to reach your long-term financial goals, investing early is as important as the actual amount invested.

In addition to the amount you invest and an early start, the rate of return you earn from investing is also crucial. The higher the rate, the more money you'll have later. Let's assume Chetan from our previous example, had another friend, Nirav, who also started investing at age 24, saving Rs. 20,000 a year for six years. But unlike Chetan, who earned 12 per cent, Nirav earned only 8 per cent, due to unwise investment decisions. When they all retired at age 65, Chetan would have nearly Rs. 1 crore but Nirav would have only approximately Rs. 25 lakhs! Even though Chetan earned only four percentage points more per year on his investments, or Rs. 800 per year more on the initial Rs. 20,000 investment, he would end up with about four times more money than Nirav. That's how a few percentage points in investment returns or interest rates over the long term can mean a huge difference in your future wealth. What you need to keep in mind, while seeking higher returns, is, compounding provides better rewards for consistent long-term returns, even if the returns per se are just “average”, compared to the alternative of stellar short-term returns, but poor long-term returns.

Wise investing, aided by the power of compounding, can help you attain your financial goals in life. In order to use it most effectively, you should start investing early, invest as much as possible, and attempt to earn a reasonable average rate of return over the long term.

Compared to stock investing

Overcome by the lure to earn high returns, a lot of investors take to “trading” with great fascination. What they fail to understand is that although trading has the potential to generate high short-term returns, it is rarely sustainable over the long term and hence offers poor compounding effect. This is why over the long-term, most trading strategies lose out to the simple alternative of buying and holding sound stocks, mutual funds or index funds purchased at fair prices. Investors with a medium to long-term perspective save money in broker's fees and taxes every year that compounds over time to provide an unfair advantage in the form of higher total returns.

For more on the transformative effect of compounding, readers can check out the aptly titled book The Snowball by Alice Schroeder.

The writer is a finance specialist. He can be reached at shyamscolumn@gmail.com or www.shyamscolumn.com

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