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Sunday, March 29, 2009

Compounding - Investment Management Principle

Albert Einstein had once remarked, 'The most powerful force in the universe is compound interest'. The concept is cliched, overused from an investment perspective; it may be ill-timed to reiterate the power of compounding, especially when the market is down in the dumps. Buying stocks for longer duration of time frame helps you in utilising benefits of compounding and fetching phenomenal investment return from your stock investing.

What Does Compounding Mean?
The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Also known as "compound interest".

Disciplined investment can go a long way, one need to get bogged down by intermediate glitches such as these. Let's take an example. Rahul, 25, had only one goal: he wanted to become a millionaire. No, he wasn't inspired by the movie Slumdog Millionaire, for everyone is not lucky enough to win a million on a game show. He wanted to put his money to hard work!


What is compounding?
We aren't defining the mathematical term, the achievement of academics is to apply them in daily life.

The wonder of compounding (in investing terms) is to make your money work, to transform it into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on your asset's reinvested earnings. Compounding works on two basic premises: re-investment of earnings and time.

Simply put, the longer time you leave your money to compound, the higher is the wealth you generate.

Read: Value Stock Investing - How To Buy Top Stocks - Buy Stocks After Analysis

Start early, save consistently
Often, it is seen that investments are generally the last thing on your mind in your early 20s. You probably didn't know a thing about investing during your college days. The pocket money went straight to splurging on shopping, gadgets, theatres etc. The earlier you realise the importance of investing, the more time you would have for your money to compound and build a huge corpus. The adjacent table shows a simple representation of the power of compounding.

The table shows that if you save Rs 10,000 per month for 10 years (that is Rs 12 lakh at the end of 10 years) and if it compounds every year at a rate of 8 per cent then at the end of the 10th year you will get a corpus of Rs 18, 29, 460. But if you continue investing Rs 10,000 per month for another 10 years (that is Rs 24 lakh at the end of 20th year) and if this money compounds itself at 8 per cent then you build a corpus of more than Rs 58 lakh. That is you double your invested amount in 20 years.

Click image to enlarge
Doesn't sound very mouth-watering, does it? No. Well, the power of compounding works handsomely when you let your money grow for a longer period of time as the table and the two illustrations below highlight. Apart from the time factor the other assumption that changes is the rate at which your money grows.

Now, if the same Rs 10,000 per month grows at 10 per cent per annum then your Rs 24 lakh (at the end of 20th year) will get you an amount that is more than three times (Rs 75 lakh) your invested amount (Rs 24 lakh). Likewise, if the same amount of Rs 10,000 per month (Rs 24 lakh in 20 years) compounds at 15 per cent every year for 20 years then you end up becoming a crorepati: that is, your actual investment of Rs 24 lakh returns Rs 1crore and 49 lakh.

Checkout: How to buy stocks ? Buy stocks with confidence

Numbers do look good when tabulated; however, it is indeed a Herculean task to translate them into reality! You may observe now that it is not just time and money that commands the direction in which your corpus grows; there is one more important parameter which determines the same: rate of returns. For nobody can give you an assurance that your corpus will grow every year at a given rate.

Discipline & diversification
Consistency scores, both in cricket and in investments! Not being perturbed by intermediate glitches (such as the current one) will help you curb the key fear factor which is detrimental in erosion of your money.

To achieve the best risk-adjusted returns, it becomes absolutely necessary not to put all your money in the same basket. Having a judicious mix of debt and equity is equally important whilst you embark on your journey to become a millionaire.

Rahul had a moderate risk appetite and was keen on buying stocks especially at current levels given the fact that they are available at discounts to their actual value. He had limited knowledge about equities hence he start off with equity mutual funds, which is also an ideal way to begin investing into equities.

Often, one is unsure of how much exposure one can assume: a thumb rule is to have equity exposure at 100 less your age; for Rahul it translates into 75 per cent (100 less his age, that is, 25 years) into equities and 25 per cent parked in debt (say fixed deposits for safety).

Diversification is what will determine what returns you achieve. In table 1, we have illustrated three scenarios on returns: 8 per cent, 10 per cent and 15 per cent. Although risk is directly proportional to returns, one should aim to achieve optimal returns at risk-adjusted levels.
Patience is a virtue

Do not touch your investments; don't react to the prime sentiment of the day. Compounding only works if you allow your investments to grow over a longer period of time. It is exactly like growing a tree to bear fruits. The results will seem slow at first, but persevere.

We quoted earlier that numbers look good when tabulated. However, transforming them into reality could be a Herculean task. Well, not quite. An investment of Rs 10,000 per month for a period of 10 years has yielded an average of 12 per cent on a year-on-year basis even after a huge market fall as the adjacent table illustrates.

Most of the magic of compounding happens only at the end. It's time you planned on how to be a millionaire and maybe not the Slumdog way!
Reference: Rediff & Investopedia

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