Whether it is the Internet, television or bookshops, there is no dearth of people giving their advice and formulae for you to become rich. With a deluge of advice coming for free, or at a fee, how does a common investor deal with them? From his or her point of view, the objective is to have enough money for major future needs when the need arises, be it home buying, children’s higher education or regular income and health expenses in retirement. With home prices in India mostly appreciating, higher education costs growing faster than general inflation and increasing life expectancy prolonging retired lives, the need for saving substantial sums for the future is becoming more important than ever. In this backdrop, it is the old and well-known concept of compounded growth that we all learnt in our primary school that is becoming more relevant.
Power of compounded growth How powerful can be a concept where through regular contributions over time, thanks to an ever-growing principal, your accumulation keeps growing to staggering levels? The answer: much more than what people often imagine. Time to revisit a famous story related to compounded growth.
An ancient king wants to reward the man who invented chess with anything he wants. The smart inventor seeks wheat grains from the king but with a unique condition. The number of grains should be such that the first square of the board should have two grains and each subsequent square of the chessboard should have the square of the number of the previous square of the chessboard. It quickly dawns on the king that he will not have enough wheat in his kingdom to reward the inventor. The last square will require grains equivalent to the astronomical number of two raised to the power of 63.
Compounded growth of money Unlike the investment gurus telling you new tricks to get a higher return for your investments, in case of compounding, you just need time at hand. So, if your investment is growing at 8% annually, your money multiplies by 1.16 times after two years. This becomes 2.15 times in 10 years and 4.66 times in 20 years. This is true for just the first investment. However, when you regularly invest, you create numerous streams of growing money that begin at different points of time and are accessible when you need them in the long-term. The result: an impressive accumulation at the end of a long period.
Importance of early start
While the power of compounding is there for all to see, few people actually manage to harness it. This is due to two common misconceptions. First, many people who think that a little delay doesn’t matter, the truth is that it does. If you invest Rs 5,000 every month and the money grows at 8% annually, you save Rs 29.45 lakh after 20 years. Start five years later and you save Rs 17.30 lakh, or 41.25% less for a 5-year delay (See: Why It Pays Handsomely To Be An Early Bird). Second, people think that drawing from the saved money for immediate needs like a family function makes no difference. From our example, we can visualise the unfavourable impact such moves can make.Clearly, it is important to have an early start to investments and to keep doing it without any break for long periods to fulfil our life’s most 49 important dreams. To ensure regular investments, experts recommend that you commit to a regimen where there is a commitment to a regular investment amount that gets invested when you get your pay and before incurring any expense. For investors who find it difficult to get into a regular investment regimen can consider regular monthly investment options such as systematic investment plans (SIP) offered by mutual funds, monthly premiums for life insurance-cum-investment plans and recurring deposits (RDs) from banks. Now that we are aware of the need to harness the power of compounded growth, how does a young investor, early in his or her work life get started with making regular investments in future? Here is a gameplan (See Get Started With Regular Investments).
Getting started with regular investments
Before you can start your regular investments, identify the major needs that you need to meet, the amount required and the regular investments to reach that amount. Of course, the earlier you get started, more time you get to help your money benefit from compounded growth. If you intend to get into a regular investment regimen like mutual fund SIP, you could earmark an SIP or a combination of SIPs for the particular financial need, be it home buying or children’s higher education. The choice of the investment can be according to the time you have at hand. Thus it could be a debt mutual fund for home buying 3 years from now and equity mutual fund for child’s higher education 18 years later. You can supplement your regular investments with lumpsum like bonus, refunds and gifts that come to you from time to time.
The areas covered in our discussion so far look straightforward, don’t they? Yet, there could be a slip between the cup and the lip when it comes to accumulating substantial savings if people make four common mistakes.
Let savings vegetate
Many people save well. But that is not enough since you need to deploy it meaningfully so that it grows well to serve you tomorrow. Unfortunately, many people let their savings vegetate in low interest-paying bank savings account or in the form of cash at home.
There are many who make investments without being aware of the associated risks to their principal or returns. Consequently, they fall short despite regular investments.
Spurred by recent developments Regular investments often get disrupted by knee-jerk responses to news and personal developments. They lead to premature exits or ill-advised and additional investments influenced by recent performance of certain investments or an investment class like equities and market events.
Chasing returns instead of financial goals
Often the focus on growing money makes investors lose sight of future needs. As a result, investors take unduly high or low risk that impacts final savings amount.
Clearly, time has come for us to get back to a simple and easy to follow approach of creating wealth by harnessing the power of compounded growth. With it, you keep the stress out of wealth creation, be it tracking the markets or being alert to respond in time to various changes. The old chessboard story still remains relevant in our lives today as it did in the past.