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Invest early to gain from compounding

Last Updated: Sat, Sep 21, 2013 18:54 hrs

Albert Einstein once said that "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.

Most individuals forget one key factor to build wealth - start saving early in one's career. The benefits of compounding work best over longer periods of time. And if you want more time to work for you to compound wealth, you have to start to invest very early.

Consider this, adding twenty five more years of compounding can increase your wealth by close to Rs 7.7 crore (see box: Compounding Magic).

How compounding helps
The basis of the compounding principle is that you can earn interest on the interest earned. It's a concept wherein the returns that you have earned will start generating returns for you, that is, money starts working for you. Let us look at an example which explains the power of compounding. Manish and Suresh are two colleagues. Both are 25 years old and earn same amount.

Manish knows the benefits of investments. He has started investing early and has adopted a systematic investment approach in order to meet his financial goals. Suresh, on the other hand, is a spendthrift and has decided that he will start investing only after five years. He has not paid much attention towards investment and financial needs. Let us see what will be the accumulated corpus with them when they retire at the age of 55 years, that is, 30 years from now.

We have assumed that Suresh will start his investments after five years, and he will will start by investing Rs 40,000.

Plan for retirement
A benefit of early investing is when one is looking for building the corpus for retirement. Investing early will help to reduce the impact or the monthly investment amount required to build up the required corpus. It also helps to tackle the inflation impact in the long run.

We have considered a scenario where the corpus required on retirement is Rs 1 crore and the retirement age is 55 years. So in order to achieve this desired corpus level what would be the monthly investment amount required. If a person starts investing at the age 25 years then he will have to invest approximately Rs 7,000 per month, whereas if one starts investing at the age of 35 years then the monthly amount required for investment would be approximately Rs 18,000. Thus, if started early one can benefit from the power of compounding which will reduce the investment amount required.

Where to invest
Choosing the investment avenues is also part of financial planning. Before deciding on any asset class one should consider his risk appetite and choose the investment avenue accordingly. For instance, in case of direct equity the risk is high, while in case of equity Mutual Funds the risk is moderate-high. In case of debt, Public Provident Fund and Employee Provident Fund are low risk investments, while debt MFs are moderate-high risk. In case of bonds - government and corporate - the risk is moderate to high. In case of gold Exchange Traded Funds or gold funds, the risk is moderate-high.

Investing early will also benefit in designing the portfolio as one can consider taking higher risk. If investment is started at an earlier age one can allocate a higher proportion towards equity, which helps to earn higher risk adjusted returns. However, towards a later stage of life one should consider more debt oriented instruments, which will reduce the impact of market volatility in the portfolio.

It is always advisable to have a well diversified portfolio, which includes other asset classes apart from equity. One can even consider adding gold and debt mutual fund to the portfolio as they have inverse relation with the equity markets and, hence, reduce the impact of market volatility in the portfolio.

Cover risks
One should even consider taking adequate risk cover in order to hedge the risk associated with life. One can consider taking a term plan which offers higher risk cover at a very low premium. Even health cover should form part of the portfolio; this cover should be over and above the one received from the company.

  • Start investing as early as possible
  • Consider the factors like age, risk profile etc. before deciding on the investment avenues
  • Have a well diversified portfolio
  • Have a adequate risk cover for life

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