The word magic may take you down the realms of fantasy. So wondering what magic has got to do with the money?
No, it is not a magic mantra to make you rich and wealthy overnight. Rather, it is just a prudent investment advice. The income generated from an asset is reinvested. Thus, the earnings from the investment also work at creating more income. That’s the magic of compounding.
In simple words, earnings generated from earnings are called compounding. Most financial planners would tell you that saving on a regular basis is the best way of making your investment grow. That is what our fathers and grandfathers have been telling us from our childhood. Save regularly and ensure that your investment grows manifold. SIPs also exploit this magic of compounding to generate regular and consistent returns over a period.
Using the magic of compounding to achieve financial goals
Saving is a habit that one must inculcate at a young age and it’s not a difficult task indeed. The earlier you start, the earlier you can achieve and even surpass your goals. The early bird gets the worm. Similarly, those who start earlier would have the magic of compounding working for them at an earlier age, thereby creating wealth.
A simple example that explains the magic of compounding can be found in a mythological story and it goes like this; A king, who lost a battle, asked the victor to grant him double the number of grains as the previous square on a chess board. That means, if square number 1 has 1 grain of rice then square no 2 would have 2 grains, square 3 would have 4 grains, square 5 would have 16 grains and so on. The victor agreed and then watched in awe as the numbers added far greater than all the rice that could possibly be produced in many centuries!
This story is often told to children to explain the power of small savings and how it can reach epic proportions through proper planning. Achieving financial goals and being financially secure is not magic or a fairy tale.
Like I have been telling you all along, start young to reap the best benefits. The longer your money stays invested, the longer you can allow it to compound. Like a fine wine, that blossoms with age, so too would sound investments. Ensure that you have a diverse portfolio to hedge risks and watch the power of averaging and the magic of compounding help you achieve financial security in a lesser time. Remember, interest is earned on even a small amount of money.
Let’s understand this with an example:
Suppose Ram starts investing Rs1,000 monthly, at the age of 30 and Shyam starts investing Rs 2,000 monthly, at the age of 45. Both decide to retire at the age of 60 and the invested amount is compounded monthly. You can see the difference in the wealth that both have accumulated at the time of their retirement in the table below:
You can see in the above table, Ram started at an early age and Shyam started at a later age. Even though both of them invested the same principle amount, Ram’s corpus is more than twice the corpus accumulated by Shyam, at the time of their retirement. That’s what compounding can do to your money if you start at an early age.
A small difference in the interest rate has a big difference in your return over a period of time.
Let’s take an example:
You have invested a lump sum of Rs500,000 for a period of five years. Now, by the principle of compounding, the return on your investment at 8% after five years will be Rs734,664 and at 10 per cent will be Rs 805,255. Now, here is the magic of compounding; for a difference of two per cent in the interest rate, the difference in the return is Rs 70,591 (Rs. 805,255- Rs. 734,664).
Compounding and Investment Planning
Investment Planning is all about managing risks and maximising returns. Higher risks mean higher returns and vice versa. Set your financial goals early. To do this, you must plan out your life goals and should be aware of the available income at different stages of your life. Next, you must identify investments that will help you achieve your financial goals. Make sure that you calculate your investment goals across your time horizon. Given time, even small investments will grow significantly.
A 30-year-old man would have a different risk appetite and time horizon when compared to a 45-year-old man or a 62-year-old man. Thus, appropriate financial goals must necessarily be time bound. A person thinking of buying a house in five years needs to decide his budget and plan to ensure that he has the down payment available in five years time. Like we often hear, slow and steady wins the race. Therefore, nurture your tree of wealth each day and reap rich dividends in the future.
Thus, make small savings from your income to make provisions for your sunset years. When planning for your future, make sure that you follow a disciplined approach and invest systematically. Even a modest initial investment will multiply manifold using the power of compounding.
Final Word: Compounding means earning interest on interest. The earlier you start, the more magic you can see of compounding and the wealthier you will be.
So what are you waiting for? Invest right away and start enjoying the magic of compounding. Transform your hard earned money by teaching it to work for you so that you can sit back and relax!
The author is head and founder of Mumbai-based financial advisory firm Money Mantra. He can be reached at firstname.lastname@example.org