This is just a simple example for youngsters to understand how power of compounding works. It’ll explain how power of compounding can help you reach your goals if you start investing at an early stage of your life. First of all, let’s understand what compounding exactly means?
What is Compounding?
Compounding means – your money grows year by year. The value of money does not come down, it only increases. Let me take an example – Suppose you’ve invested Rs. 1,00,000 (1 Lakh) in FD for 1 year and the interest rate is 6%. This means that after 1 year, the value of 1 Lakh would be 1.06 Lakhs.
Now, again if you invest 1.06 Lakhs in FDs that give an interest rate of 6%. The value would be 1.12 Lakhs after 1 more year.
If you keep investing this amount year after year, the value of your invested amount will keep on increasing. The value of 1 Lakh after 30 years would be 5.75 Lakhs assuming 6% interest rates on FD. This is called compounding, where your money grows on a continuous basis.
Does Compounding Work In Equity Mutual Funds?
The answer is No.
The ideal definition of compounding doesn’t work in equity mutual funds. There is no surety that your investment will grow every year. For some years, it may come down, for other years, it may go up. Equity mutual funds are not like fixed deposits where the money grows with each year.
Suppose you invest 1 Lakh in equity mutual funds and suddenly the market crashes. The value of 1 Lakh may become 80,000 next year. However, the same investment value can be 1.20 Lakhs next year if the market goes up.
The ideal definition of compounding doesn’t work in equity mutual funds but everyone still suggests investing in equity mutual funds. The reason is that most of the debt instruments would not be able to beat inflation in the long-term. Secondly, you will need a higher investment to reach your financial goals if you invest only in debt instruments.
So, in equity mutual funds, the returns are called XIRR. Suppose you have invested 1 Lakh in equity mutual funds and the value after 30 years is 5.75 Lakhs. In this case, the XIRR would be 6%.
In the long-term, it is assumed that equity mutual funds will give better returns than fixed instruments. (Again it is assumed, there is no guarantee.)
Coming back to power of compounding/returns, let’s understand it with an example of two friends named Ramesh and Suresh.
How Power of Compounding/ Returns Work In The Long-term?
Ramesh and Suresh were 2 friends. Both started working at the same age of 23 after graduating from a reputed engineering college. Both decided to retire by age 60. Ramesh started investing the very the first year after getting the job while Suresh thought of starting investments at a later stage. Ramesh tried his best to convince Suresh. But Suresh was adamant to enjoy life after putting in so much of hard work.
Ramesh started investing 10,000 per month in equity mutual funds (his PF was already getting deducted as debt part of investments). Ramesh invested this amount of 10,000 per month for next 7 years.
So, if we calculate, how much Ramesh must have invested in 7 years = 10000 per month * 84 months = 8,40,000
Assuming 10% returns after 10 years, the value of 8.40 Lakhs would be 11.91 lakhs after 7 years.
Now, if Ramesh stops investing after 7 years, and waits till age 60, i.e., another 30 year. Do you know how much this amount (11.91 Lakhs) will grow, assuming 10% returns?
The value of 11.91 Lakhs would be 2.08 Crores after 30 years. Yes 2.08 Crores.
Coming back to Suresh, he decided to start investing at age 30. He thought that by investing for 7 years, he would also be able to achieve the same amount as Ramesh. (Or may be a little less.)
But do you know, to achieve this 2.08 Crores, Suresh needs to continuously invest for next 30 years, assuming returns of 10%. Yes, he must invest 10,000 per month for next 30 years. Because only then he would be able to achieve the corpus of 2.08 Crores.
If he follows the footsteps of Ramesh, i.e., invests for 7 years and stops investing at age 37. The value of the corpus would be only 1.06 Crores at age 60.
I am not trying to explain the benefits of equity mutual funds here. The same example will work if you invest in FDs too, assuming 6% returns. The concept of power of compounding is about starting early and staying invested for the long-term. If you are comfortable with debt investments, start investing more. The earlier you start, the easier it would be to achieve your goals.
The classic example of this type of investment is PF amount. Ask people who have retired recently and have never touched their PF amount during their service tenure. In the initial years, it often seems like the amount is not growing. But in the final years, they realize how fast the amount is growing.
So, start investing and start as early as possible.