The most important factor for the Compounding Magic to work

In all my years of experience in the financial advisory profession, I can surely tell that the science behind getting wealthy is very elementary. There is no secret to getting wealthy. Getting wealthy is not just confined to people who are earning high incomes or doing business or investing in properties or taking bets in stock markets, commodities, foreign currency, etc. Earning big money is a skill, but managing that money well is even a bigger skill. Even an individual with average income can become wealthy.  Let me show you how and prove with numbers:

A common Analogy to Compounding

As a snowball rolls down a hill, it picks up more snow making it bigger.  This in turn causes the snowball to pick up more snow till the time it rolls over and over again turning it into a giant one. Similarly, compounding has a snowball effect on money. Here are three important things you should know about compounding. Let us examine with numbers to understand what compounding can do to your money:

Before I illustrate on how the magic of compounding works, take a look at this equation which explains the concept of compounding well.

PV*(1+R)N= FV

PV = Present Value

R = Interest Rate

N = Number of periods (Amount of time)

FV = Future Value

This formula basically implies that an X amount invested today at a certain rate for a certain period of time will fetch you X+Y.

Do you know which is the most important variable in this formula? No, it is not the rate of return you earn but the time you give to an investment to grow and compound. Let us understand this further with examples:

Multiplier effect of compounding – how your money grows faster

Suppose Mr.A invests Rs.1,00,000 at 10% for a period of 15 years. As seen in table 1, his money doubles in 8 years to over Rs.2,00,000. But later it only takes half of the time, i.e., just an additional 4 years to triple the investment to about Rs.3,00,000 and then 3 years to reach Rs.4,00,000. This is the power of compounding, how investing money makes more money for you and gains momentum to multiply faster.

How starting early helps:

This is one of my favourite illustrations. Here, Mr.A starts investing Rs.50,000 every year from the age of 23 at the rate of 10 per cent p.a. He stops investing as he turns 31 but does not redeem whatever he had invested in those 8 years. On the other hand, Mr.B starts investing late from the age of 30. He invests Rs.50000 every year till the age of 65 at 10 per cent p.a. Can you guess whose corpus would be higher at 65? You will be amazed to find out from the table that Mr.A accumulated Rs.1.61 crore while Mr.B lagged behind at Rs.1.49 crore. Despite investing regularly for 35 years, Mr.B could not match Mr.A’s corpus. Although Mr.A had stopped investing after 8 years, he had the advantage of starting early. Those 8 years allowed his money, time to compound and grow. That is the magic of compounding. While this was a hypothetical example, practically a person in his working years continues to invest throughout his working life as his income rises. So, imagine the corpus Mr.A would accumulate had he continued investing till retirement. Assuming he continues to invests Rs.50,000 at 10% compounded average return till retirement, the accumulated corpus comes to a whooping Rs.2.95 crore.

What happens to your investment kitty when you withdraw intermittently?

This is another interesting example showing how you lose the benefit of compounding as your regularly withdraw money from your investment kitty. Suppose, you invest Rs.35,000 annually for 25 years at 10 per cent p.a. Assuming you have not withdrawn any money during this period, your accumulated corpus comes to Rs.34 lakhs. Now taking the same example, assume that while you are investing regularly, you are also withdrawing 20 per cent of the investment value in the 5th year, 10th year and so on. The resultant corpus accumulated after 25 years comes to Rs.19 lakh. Withdrawing just 20 per cent of the corpus every few years has reduced the compounding impact and you end up with nearly Rs.15 lakh less in your total kitty. That is a huge difference.

I am not suggesting here that you should not withdraw at all. But investments when haphazardly done lead to random withdrawals which is not good for your long-term goals. I have observed many people withdraw from their PPF/EPF accounts for no urgent reason. If an investment is mapped to a particular long-term goal, the focus and motivation to achieve the goal stays clear irrespective of the product performance. So, plan your long-term goals thoughtfully like retirement, child education, etc and let your investments compound.

If you understand how compounding works, its multiplier effect and benefits of starting early, you will understand that creating long term wealth requires patience and discipline in investments. You not only need to invest regularly but give your money time and the opportunity to grow. This will be taken care by the eighth wonder of the world – Compounding!

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