Friday, 31 December, 2010

Using Power of Compounding - A New Year Resolution

Using Power of Compounding - A New Year Resolution

Einstein called it the eighth wonder of the world. Financial pundits from around the world have sung paeans in praise of it. I don't think that I can find any new word to praise the truly magical Power of Compounding.

Instead, I've created a simple illustration to demonstrate the power of compounding - First, take a look at it:

I'll strongly urge you to take a printout of the illustration given above and pin it up at a place you'll be able / forced to see almost on a daily basis.

Some observations to note and conclusions that I'd like to draw from my illustration:

  • So-called "risk-free" assets like PPF, Bank Fixed Deposits, etc. become highly risky assets over a period of time. Thanks to inflation.
  • So-called "risky" assets like equity shares, mutual funds, etc. become your dearest friends to beat the demon of inflation in a virtually risk-free manner. This is not automatic. This is achieved thanks to the amazingly powerful, yet simple tool - the Power of Compounding! We need to learn to use the power of compounding to our advantage.
  • The distinction between the returns generated by stuff like PPF, Bank Deposits, etc. vis-a-vis stuff like Mutual Funds and Equity Shares is borne out when you look at the highlighted portions of the illustration.
    • Rs. 5000/= per month invested in PPF for 20 years is literally mauled by just 20%, i.e.., Rs. 1000/= invested per month in shares and mutual funds for 20 years.
    • In fact, even a sum of Rs. 18 lakhs invested over a period of 15 years (at the rate of Rs. 10000/= per month for 15 years) ends up generating a sum that is comparable to the amount generated by a relatively miniscule Rs. 2.4 lakhs invested over a period of 20 years (at the rate of Rs. 1000/= per month for 20 years)
    • If we were to consider the example of a lower middle-class family saving relatively minor sums of Rs. 500/= to Rs. 1000/= per month, the results are similar. A sum of Rs. 2.4 lakhs invested over 20 years in PPF generates less than 40% of what you will get by investing half the sum (Rs. 1.2 lakhs, at the rate of Rs. 500/= per month) in equity shares and mutual funds.
  • Inflation is a monster that is only going to be too real. You don't even need a financial expert to enlighten you. Just try to recall what you paid for a tube of shaving cream, tooth paste, litre of petrol, a cup of coffee, a dinner at a restaurant, etc. around a decade back and around 20 years ago. And compare the same with what you're paying now for the very same items.
  • Life style inflation is a bigger monster that is not even recognised by the usual bunch of financial advisors. If you were going by bus 10 years back, you're probably riding a two-wheeler or driving a car now. A monthly dining out practice has morphed into a weekly affair. 4-6 sets of trousers, shirts, saris and salwars per annum has transformed into 10-12 per annum. A toffee to all classmates on a kid's birthday in yester-years has given way to full-fledged parties. A birthday cards to friends has been replaced by supposedly minor gifts. Akshaya Tritiya was unheard off earlier. Today, you can't avoid picking up some jewellery on that day. Social drinking was almost non-existent earlier. It is increasingly becoming the norm today. A holiday meant a trip to the native place. Today it is to tourist destinations for the middle class and exotic locations for those who are richer. To sum up, Life style inflation is truly unnerving and you can't escape from it. The figure of 6% that I've assumed for inflation is almost a joke. And a cruel one at that. To my mind, the total inflation (the actual inflation plus the life style inflation) figure is likely to be nothing less than 15% per annum for a vast majority of us.
  • If you end up investing your hard-earned savings in stuff like PPF, Fixed Deposits, etc., you're going to be a sitting duck waiting to be butchered by the monster of inflation. Believe me, there is no escape.
  • While income levels are increasing, savings are actually decreasing as a percentage of income and, in many cases, even in absolute terms.

To finally sum up,

This is both a New Year Gift to each of you and a dire warning to each of you.

Use the magical Power of Compounding, or else, be prepared to face all the negative consequences that are bound to follow.

Before it is too late for you.



Using Power of Compounding - A New Year ResolutionSocialTwist Tell-a-Friend

1 comment:

Durga Nandan said...

The FD most of the time gives a negative return when we calculate the value of the money with inflation. Not many know that..

Nice Post..
Durga :)

Related Posts with Thumbnails