“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
It is quite common to refer to the wonders of compounding However, this is often forgotten in financial planning. The pace of compounding is quite low in the beginning as the capital invested is very less. This is the period when most people get disappointed. They see that despite diligent and systematic investing over a decade, the corpus is not yet significant. They start questioning it and almost give up when it is time to renew the commitment as we are so near our goals. I have created some charts which will explain this:
It takes ~15 years to reach 1 crore mark but in ~30 years, you could get 8 crores.
Assuming monthly investment of 20,000 and annualized return of 13% (quite reasonable for equity funds and below the historical return), we can reach 1 crore mark in 14.8 years. After that the rise in portfolio value is quite dramatic. Indeed, hitting the first crore mark takes the longest but the real benefit of compounding kicks in then. So, it is important to continue. The Key takeaway is to invest aggressively in the beginning.
How much you invest becomes less important as time passes.
the chart below, I show the contribution of invested amount to the overall portfolio value. As we move on, the contribution of invested capital declines as compounding kicks in. If you were to invest just for 10 years and leave the money untouched (@13% CAGR), your portfolio will still be 5.45 cr after 30 years, compared to 7.5 crores (if you were to invest 20000 every month for 30 years). Again, the key takeaway is to invest aggressively in the beginning.
Fixed deposit or equity- it can make a world of difference.
Now, if I am investing for long-term, does it make sense to invest in fixed income. Unless you need the money in short-term, you will just have to work longer if you keep on investing in fixed deposit type of assets. If you invest 20000/month in equity (@13% annualized return), you will reach 10 crore mark in ~32 years. However, if you invest in fixed deposit (@8%), you will need 45 years to reach the same amount. Even ignoring the tax implication, you are adding years to your working life by playing it too safe!
Finally, the key take aways are:
- To benefit from compounding, invest for long-term and remain invested for long-term.
- Investing aggressively can be a help in building a sizeable corpus by the time you retire.
- Investing in fixed income for long-term is similar to adding years to your working life.
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