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The power of compounding

The key to wealth generation in the current era is to use the power of compounding effectively to your advantage. Probably the most important thing you need to know about building wealth is the power of making regular periodic investments and reinvesting rather than spending profits.

india Updated: May 14, 2006 00:21 IST

The key to wealth generation in the current era is to use the power of compounding effectively to your advantage. Probably the most important thing you need to know about building wealth is the power of making regular periodic investments and reinvesting rather than spending profits.

The power of compounding utilised over a long period of time as you start early, could give substantial returns at a later stage. On the other hand, starting to invest late in life could have a significant impact on your wealth-generation capability at a later stage. So how does the power of compounding work?

Just to cite an example, suppose there are two gentlemen – Mr A and Mr B. Mr A starts saving Rs 750 per month from age 28 years and is determined to keep investing for another 15 years. After 15 years, he decides to stop investing and decides how much of corpus could be kept for his retirement and how much to go for, say, taking at least one holiday trip within the country annually.

Considering the fact that the Indian stock markets would do well for another 10 to 15 years despite even major corrections in the BSE Sensex, the gains would be manifold on the small investment made every month.

On the other hand, Mr B starts investing Rs 5,000 per year when he is 40 years old and continues investing this amount every year till he is 50. Considering that both earn a 15% post-tax return per annum on their investments, the wealth of both investors would be like this:

Mr A: The Rs 750 monthly investments made between age 28 to 53 will aggregate to around Rs 27.7 lakh by age 60 and Mr B’s Rs 5,000 annual savings started at age 40 will aggregate to Rs 25 lakh when he is 60 years through investments made in Mutual Funds. This exposure to equity reduces as the age advances for both investors.

It is to be remembered that every day that your money is being invested in Mutual Funds (could be also with a Systematic Investment Plan), your money is working for you even at times when you have not checked your annual financial statements sent by the asset management company for a long period of time.

So whenever you consider an investment option, remember to evaluate the expected rate of return in real terms after a minimum of 10 to 15 years, before you decide to set aside a fixed amount of money every month or year for investments.

It is also to be remembered that inflation and taxes are important factors to be considered while evaluating investment returns and how a little more attention to your investment decisions can result in a significant improvement in your financial health at a later stage. This clearly means that your tax planning must go in tandem with your desire to invest regularly in Mutual Funds. So, if you want to lead a happy retired life at a later stage invest now!!

One last word of caution: Evaluate the performance of all the Mutual Funds you are considering for the past 3 to 5 years through advise from knowledgeable wealth managers and investment advisors. There are many Mutual Funds, which enter the market during boom time for quick gains by promising high short-term returns. Stay clear of such Mutual Fund offerings.