When compounding, benchmark performance against the index, peer group

Talk to any financial advisor and the one advice you will hear is to start investing early so that the power of compounding works in your favour. But what exactly is it? Let us understand the power of compounding with an example of two investors - Ajay and Vijay, who invest Rs 10,000 in an instrument giving 10% return per annum. Ajay chooses to withdraw the interest of 10% every year while Vijay opts to reinvest the interest back in the bond itself. How do they fare at the end of five years?

The beauty of the power of compounding is that with every passing year, the impact of compounding increases. You can see that by the end of year 5, the interest on interest is earning you more than the interest on the principal. That is what power of compounding is all about. The longer you stay invested in growth assets like equities and equity funds, the more your principal and returns earn further returns.

Why do some people end up richer with the same assets, to begin with?

Look around you and you will get to see many instances of people who end up with different levels of financial success despite having the same level of income. The difference lies in how hard you make your money work for you. That comes from the power of compounding. 

Let us take a simple example. If you are doing an SIP of Rs 10,000 per month but decide to put that money in a debt fund due to your conservative approach, then what happens? A debt fund earns around 5.5% return in post-tax terms. At that rate, you will need 16 years to double your money.

Obviously, you are not going to create any serious wealth with this approach. Let us look at how two persons with the same level of income can diverge widely in wealth creation based on they make the power of compounding work for them. For compounding to work, you need time and also the choice of right assets.

Both the above investors have invested Rs 24 lakh as principal. The only difference is that the early investor starts 10 years earlier than the lazy investor. The result is that the wealth of the early investor has grown to two times the wealth of the lazy investor purely because he started out early. That is the power of compounding at work. 

Growing wealth, in the long run, is about leveraging the power of compounding to the fullest extent. Here are some four ground rules to follow.

Start investment early as we saw in the case above. The earlier you start, the longer you earn returns and the longer your returns earn additional returns. More than the size of the investment, it is the early start that matters.

The real power of compounding is in equity. Even if you invest regularly in debt funds, there is a limit to the wealth you can create. Equities and equity funds give you the full benefit of compounding to create wealth over the long term.

SIP is not just an investment but also a discipline. The rule you need to follow is not to disturb the flow of wealth accumulation. Power of compounding works best when you do not withdraw funds in between. That will defeat the purpose of building wealth over time. Don't treat your mutual fund SIP like an ATM.

For the power of compounding to work, you need to continuously benchmark investment performance against an index and also against the peer group. If your funds are consistently underperforming the index, then the power of compounding is unlikely to work in your favour. 

Power compounding is the key to building wealth. That is what bridges the gap between your limited resources and wealth targets. 

The writer is chief revenue officer, Angel Broking