Compounding is an excellent hedge against inflation
PremiumThe major component in the compound interest calculation is time
We tend to spend our entire lives working and trying to identify and capitalize on avenues that can maximize our earnings and assist us in building our desired retirement corpus. However, what we fail to take into account are inconspicuous taxation norms, market volatility and inflation.
To a certain extent, one can figure out a way around taxes and even make safe investments where market volatility is inconsequential. However, inflation is the prime reason that the masses’ accumulated wealth doesn’t stand the test of time.
Over time, inflation reduces the value of savings. This happens because a steady increase in prices causes the purchasing power of your holdings to go down. One would be tempted to assume that the only tangible workaround in this scenario is to figure out more ways to amass wealth so as to balance out the effect. Thankfully, there happens to be one excellent hedge against inflation: compounding.
For long, we have been offered paltry proportions, rallying up to 10% at the most as interest on our savings. This obviously isn’t an optimal way to generate wealth. This is where compounding comes into play. Let us take a case, wherein you have invested ₹100 in two places, one of which would provide you with a simple interest of 10%, and the other would provide you with a compound interest of 10%. In the first case, you would earn ₹10 every year as interest and at the end of a 5-year period, you would have ₹150 in hand. In the second case, however, you would earn ₹10 as interest in the first year, ₹11 in the second, ₹12.1 in the third, ₹13.3 in the fourth and ₹15 in the fifth, making the total of your investment along with the gained interest come up to ₹161.
Now, a difference of ₹11 from both cases might not seem much, but let’s take into consideration one other thing. In the 5th year, you made ₹10 with simple interest, whereas you made ₹15 with compound interest. Speaking in terms of percentages, that’s an exponential 50% difference right there. This goes on to illustrate the power of compounding.
The reason compounding makes sense is that you could be boosting your income exponentially at a much faster pace with the same amounts as before. Most definitely, at some point or the other, we have all dreamed of having built a corpus spanning well into crores, but we have also been demoralized, thinking that it isn’t possible with nominal savings.
Let us assume that you wish to accumulate a corpus of ₹10 crore in your working career of 35 years. You can do this by saving as little as ₹15,400 every month via SIPs @12% (assumed) in equity mutual funds every year for 35 years. Following this process diligently on the side for 35 years could help you build your dream retirement corpus.
So, what stops many of us from reaching this magic number? It’s our behaviour that prevents us from following the boring method of consistency and longevity. Instead, we follow a ‘start-stop-pause-restart’ process which prevents compounding from reaching the numbers we desire. The major component in the compound interest calculation is time.
The longer the money remains invested, the more exponential would be your returns because as your returns start earning, even the returns on those returns would start earning, eventually causing profits to pile up. As long as you are disciplined and setting your earnings aside regularly, there’s nothing that can obstruct the flow of compounding.
It is worth noting that the picture isn’t all rosy when it comes to compounding. There may arise a situation when you have to borrow money and that is when it might work against you; the simple reason being that just the way it can accentuate your returns, the very same way, it can cause debt to rise copiously. The time factor plays the same role here and thus, it is advisable to cut down on debt or pay it back in the shortest time frame possible. Hence, compounding is a powerful motivator to pay off your debts as soon as you can.
All in all, compounding holds the power to either amplify your savings and retirement potential or to crush you under a massive burden of burgeoning debt. Successful compounding makes it possible to squeeze the maximum returns from the money you already hold. However, compounding can also work against you, like when high interest credit card debt builds on itself over time. Thus, instead of running after the avenues offering the highest interest rates, it’s wiser to stick with the classics, be disciplined, and let time do its magic.
Anand K. Rathi is the managing partner and head - strategy at Augment Capital Services LLP.
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