Harness the power of compounding

Wednesday, 5 October 2011 - 8:00am IST | Place: Mumbai | Agency: DNA
In the book, Once Upon a Wall Street, Peter Lynch, one of the most successful mutual fund managers that Wall Street has ever seen, narrates a story.

In the book, Once Upon a Wall Street, Peter Lynch, one of the most successful mutual fund managers that Wall Street has ever seen, narrates a story.

“Consider the Indians of Manhattan, who in 1625 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 362 years the Indians have been the subjects of cruel jokes because of it - but it turns out that they may have made a better deal than the buyers who got the island. At 8% interest on $24  (note: let’s suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion.

Give Manhattan the benefit of doubt: That $28.1 billion is the assessed value, and for all anybody knows, it may be worth twice that on the open market. So Manhattan’s worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change. 

This little story conveys you the power of compounding and the fact that the earlier you start investing the better it gets.

Illustration
Let’s try and understand this through an example of two friends Ram and Shyam. Both start working at the same time at the age of 23. Ram starts saving when he turns 25 and invests Rs50,000 every year. Assuming that on this he earns a return of 10% every year, at the end of ten years, Ram has been able to accumulate Rs8.77 lakh.

However, due to financial constraints Ram is not able to invest any more money after the 10th year. At the same time he does not utilise the fund that he has already accumulated, hoping to live off it when he retires.

He lets the Rs8.77 lakh grow and assuming that it continues to earn a return of 10% p.a., he would be able to accumulate around Rs95 lakh by the time he turns 60. So the Rs5 lakh (Rs50,000 x 10 years) he had invested in the first ten years of his working life would have grown to Rs95 lakh. This even though he stopped investing entirely after the first ten years.

Now let’s take the case of Shyam. Shyam believed in enjoying life, spending money recklessly rather than save regularly.

However, at the age of 35 reality suddenly dawns upon him and he starts putting aside Rs50,000 every year. Unlike his friend Ram, who stopped after the first ten years, Shyam religiously invests the amount each year for all of 25 years i.e. till he turns 60. Now, assuming he also earns a return of 10% per year on his investments, in the end, Shyam would have managed to accumulate Rs54.10 lakh.

Putting it differently, even after investing Rs50,000 regularly for 25 years, Shyam has only managed to accumulate Rs41 lakh lesser in comparison to Ram. Remember Ram has ended up investing only Rs5 lakh in total over the ten years that he invested. In comparison, Shyam over the 25 years invested Rs12.5 lakh (Rs50,000 x 25 years). So even by saving two-and-a-half times more than Ram, Shyam has managed to build a corpus which is 43% lower! This happened because Ram started investing earlier which in turn allowed the money to compound for a greater period of time.

Also as the corpus grows, the impact of compounding is greater. Ram as we know had managed to accumulate Rs8.77 lakh after ten years after which he stopped investing, allowing the accumulated corpus to compound for 20 years more. In other words, the total life of the investment was for 30 years. However, had his investment timeframe been till he turned 55 i.e. had the money compounded for 25 years instead of 30 then at the end Ram would have accumulated a corpus of around Rs59 lakh. By choosing to let his investment run for just an additional five years, Ram managed to accumulate Rs45 lakh more.

Real life illustration
In terms of a practical example, let’s take the case of HDFC Equity Fund. The five year return of this fund is around 13% p.a. On the other hand, from inception (December 1994), the fund has returned 21% p.a. Now, had an investor invested say Rs50,000 five years back, the investment would have grown to around Rs91,000.

However, had the investment been made at the inception (allowing the money to compound over a greater period of time) the investment would have grown over 24 times to around Rs12 lakh.

To sum up, Albert Einstein himself called the power of compounding the eighth wonder of the world. In this article we have given various examples of how potent this power is when combined with its ally —- Father Time. It’s never too early nor too late to begin investing. Or to put it differently, better late than later.

— The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com


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