Power of compounding and why we fail

Have you noticed a common theme in all the stories that demonstrate to us the magic of compounding – the recipient in unaware of the existence of the principal amount and oblivious about the compounding magic that happens silently over the years. (Warren Buffet will be an exception !) Then, several years down, one fine morning, the person discovers a snow ball of cash, what luck !!

Compounding refers to the principle where the interest earned on the principal  amount is reinvested back at the same rate of return. This is opposed to the principal amount earning interest and you take the interest out.

For compounding to work, you do not take out the interest; instead the interest earned gets added back to the principal, earning interest on increased balance in the next period.

The interest is earned every compounding period, hence more the number of compounding periods, greater is the money earned via interest. This is the reason why longer time period is compounding’s best friend, but more compounding periods specifically is a better friend ie monthly compounding generates more return than quarterly compounding than annual compounding. To calculate the total amount we can expect for our principal amount invested, we can use the Future Value (FV) function with the inputs of principal amount, rate of return, period of compounding.

As an example, consider that you have Rs. 150,000/- you want to grow and two choices

[1]  in a fixed deposit at 8% annual interest rate, compounding annually for 10 years

[2] in a fixed deposit at 8% annual interest rate, compounding quarterly for 10 years

Which option will generate more cash for you?

[1] If the compounding period is 10 years (at 8% per year), the cash you receive at the end is Rs. 323,839/-

[2] If the compounding period is 10*4=40 quarters (at 8/4=2% per quarter), the cash you receive at the end is Rs. 331,206/-

The money more than doubled in both cases and everything else remaining the same, quarterly compounding makes the money work harder; thus the period of compounding matters.

Now it is a good time to understand a related concept called “Rule of 72”. It simply states that – dividing 72 by the annual rate of return, we can roughly estimate the number of years it will take for the investment to double. Conversely, if we divide 72 by the time period in which we want to double our investment, we can estimate the  annual rate of return required for the doubling to take place.

Compounding and the Rule of 72 are two of the fundamental rules that help in investing. With this you get an idea of how long it will take for you to grow money and reach your magic figure. Now that you know how much time it will take, you can speed up or slow down ie select the rate of return with the suitable investment vehicle – savings bank account at 4% rate of return (interest rate), fixed deposit at 8% rate of return or mutual fund at 10% rate of return.

Applying the rule of 72,

[1] Rs. 150,000/- at 4% in the savings bank account, will take 72/4 = 18 years to double.

[2] Rs. 150,000/- at 8% in a fixed deposit, will take 72/8 = 9 years to double.

[3] Rs. 150,000/- at 10% invested in mutual fund, will take 72/10 = 7.2 years to double.

OR

[1] Rs. 150,000/- can be doubled in 12 years if you choose a savings bank account with 72/12 = 6% rate of return

[2] Rs. 150,000/- can be doubled in 6 years if you choose a mutual find with 72/6 = 12% rate of return

It need not be a lump sum investment, small recurring amount invested regularly over a long compounding period can work wonders too.

How does compounding work for shares? Instead of interest, the payout we receive from holding shares are the dividends. Hence you can re-invest the dividends back to buy more shares of the company instead of taking the money out.

Why do we fail?

[1] Impulsive switching of funds made easy by the convenience of 24/7 banking

Apps and Internet banking has brought banking and investments to the convenience of our homes 24/7. We are now only a click away from opening a new bank account, starting a recurring deposit, purchasing a mutual fund, buying shares, applying for a credit card and so on. No hassles, no procrastination; things happen instantaneously and we can watch and monitor the progress every day. It’s easy and convenient. And herein lies the problem.

We start with a plan, decide on the amounts we want to invest and the time frame and select the suitable investment vehicle and the compounding is underway, yes we are in for the long haul. Few years down two things can happen – either we need the cash or we see another opportunity open up and we hate to miss it. All the planning exercise done few months back seems dull compared to the new opportunity in front of us. And where does the cash come from? Liquidate some of the investments we have going and switch tracks; it’s only a click away, no hassles of going all the way to the financial institution. Wait, what about the magic of compounding? We will start again !! How will we ever make money from compounding, if we keep switching tracks?

I have started on recurring  deposits hoping to save small amount for a long period, only to find myself clicking on the redeem button way before the maturity date. You constantly hear financial advisers telling you to invest here and there, to take action; turning a deaf ear to all the noise and keeping a course without shifting funds from one investment vehicle to another is easier said than done.

So will the compounding magic to work if you follow the phrase “Out of sight out of mind”?

[2] Reinvestment risk

Will it work when we distance ourselves from the equation? After the amount, the time period, the investment vehicle and the frequency of monitoring are decided in advance and then left alone to work silently in the background, while we enjoy happier pursuits with our time in the foreground. Let’s see a typical example.

Consider that you are 25 years old and have saved Rs. 500,000/- till date. Also you are not going to tap into this fund as you will meet your expenses from your current salary, at the same time, not investing anything more into this. You do not want to invest in anything risky and are willing to park the funds in a fixed deposit that gives a modest 8% annual rate of return and how much will you make ?

After 10 years, aged 35, you will have Rs. 1,079,462/- (doubled as per the Rule of 72)

After 20 years, aged 45, you will have Rs. 2,330,479/-

After 30 years, aged 55, you will have Rs. 5,031,328/-

After 40 years, aged 65, you will have Rs. 10,862,261/- a nice addition to the retirement kitty.

There was no additional funds added anywhere down the years, all you had to do was keep away from tapping into the funds and remain invested at 8% annual rate. Possible? Very Difficult.

Another reason why compounding looks good on paper than in real life is because of re-investment risk. Fixed Deposits in India offer a maximum term on 10 years during one stretch. When you decide to renew it for another 10 years, you will not be guaranteed an 8% rate again. If the interest rates have fallen, you will have to settle for a lower rate. Hence you cannot look at a same rate for the next 30-40 years.

Is there a way to harness the magic of compounding? Experts advice equity and mutual funds; within  mutual funds, Index funds in particular, but that’s another topic.

Till next post, take care.