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The Power of Compounding In Investing
April 20, 2009

The basic concept behind your increasing investments


Author : iFAST Research Team



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Clearly, the initial investment sum plays an important role in the sum of returns. Let's say you invest Rs. 10 lacs, assuming an investment return of 20%, you would get Rs. 12 lacs in one year. The sum would diminish to Rs. 1.2 lacs if you had invested only Rs. 1 lac at the same rate of return. On an absolute amount basis, the investor with more money to begin with seems to be much better off with absolute profits of  2 lacs versus 0.2 lacs. So some people may have an illusion that investment only work well for people who invest large sums of money. But investors who take up a consistent investment strategy with good, stable returns also stands to benefit over the longer term with the power of compounding at play.

Even if you invest a relatively smaller amount, you could make a very good return by making use of the power of compounding. What you need to have on your side is TIME; or simply to invest early. Let's illustrate how much Rs. 1 lac would grow at steady rates of return over different periods as shown in Table 1.

Assuming a long term rate of 8% per annum, the initial amount of Rs. 1 lac would grow to Rs. 2.16 lacs in 10 years, and Rs. 10 lacs in 30 years' time. Public Provident Fund (PPF) currently offers about 8.5% interest on the deposits. Banks Fixed Deposit (FD) interest rates tend to be volatile. Just a few months ago, banks were offering 10% interest rates for fixed deposit of 1 year term, but now they are offering around 8% for 1 year deposits.

The returns get far better if the rate of return is at 10%. In 10 years, the investment will grow to Rs. 2,59,000 and to Rs. 17,45,000 in 30 years' time. You may wonder, "What if I am good at building a diversified equity portfolio and I invest early?" Let's assume an annualized return of 15% - in 10-year's time you would have made Rs. 4,04,000  which is about 4 times of the original investment amount. The sum balloons to almost 66 times the original amount in the span of 30 years. A great value investor like Warren Buffet generated annualized returns of 20.3% in the past 43 years (Source: 2008 Warren Buffet’s letter to shareholders of Berkshire Hathaway Inc.). With the power of compounding, the investment grew tremendously to 256 times the original amount in 30 years.

Table 1: Investment Returns of Rs. 100,000 at Different Annualized Rates
Annualized Returns Examples 3 years 5 years 10 years 15 years 20 years 30 years
8% Fixed Deposit 1,26,000 1,47,000 2,16,000 3,17,000 4,66,000 10,00,000
10% Debt Fund 1,33,000 1,61,000 2,59,000 4,18,000 6,73,000 17,45,000
15% Equity Fund 1,52,000 2,01,000 4,04,000 8,14,000 16,37,000 66,21,000
20.3% Warren Buffet 1,74,000 2,52,000 6,35,000 16,00,000 40,30,000 2,55,84,000
25% 1,95,000 3,05,000 9,31,000 28,42,000 86,74,000 8,07,80,000
30% 2,20,000 3,71,000 13,79,000 51,19,000 1,90,05,000 26,20,00,000
All figures rounded off to the nearest thousands       Source: iFast Compilations

The table above illustrates that fixed deposit may look safe but would entail an “opportunity cost" of giving up investment. The interest income from the FD is taxed irrespective of the tenure whereas profits from sale of debt and equity funds are eligible for taxation if you redeem the fund units within 1 year from the date of purchase, if you redeem the units after 1 year, all the gains are tax free.

 As long as you invest early and pick the right asset class or portfolio, even a decent annualized return of 15% would bring you a long way. Investing for the long term also helps investors to tide over short-term volatility in equity markets. Long-term value investors are less likely to be scared off during volatile times as many ordinary stock investors who are sensitive to market momentum would do.

In additional to doing a lump sum investment for the long term, investors may also choose to invest regularly by using the Systematic Investment Plans. This investment strategy is suitable for long-term investors to make use of the power of compounding.

iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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