How To Make Power Of Compounding Work In Your Favour?

May 5th 2018

To understand the time value of money, we first need to understand that time has a cost. If you keep your money idle under your pillow, then you are losing out on the interest or dividends that you could have earned by investing this money. Since time has a cost, you need to be compensated and that comes in the form of interest payable. Investing in asset classes utilize the power of compounding lets you earn more returns by not keeping your money idle.

How Does Power Of Compounding Help You?

By investing in mutual funds, you allow you money the benefits of the compounding effect. That means the returns that you get are regularly invested back into the mutual fund, and hence your overall investment keeps growing since you now have more money to earn interest on. Historically, mutual funds have offered around 15% returns which have successfully beaten the effects of degrading time value of money.

How Do Asset Classes Compensate For Time Value Of Money?

Effect of compounding on various asset class returns in 10 years
In the above chart, we have plotted how various asset classes compensate for the change in time value of money over a period of 10 years. We have also adjusted for tax and dividend yield implications. For example, bank FDs are taxed at your peak tax rate and hence the effective return after tax is very unattractive. Equities have returned nearly 12.7% after considering the dividend yield. The moral of the story is that if you are looking at compensation for time value over a longer time frame, then equities is the answer.

How Rajesh Used Power Of Compounding In His Favour?

Time value has important implications when you are planning for your long term goals. Remember, the longer you stay invested in quality assets, the greater your chances of creating wealth. Here is a case study of how Rajesh gets the better of Nayan by playing the Time Value Game more smartly. Rajesh starts investing in an equity mutual fund SIP in 2015. He allocates ₹15,000 per month to an Equity MF SIP which is yields 16% returns annually. Nayan, on the other hand, starts later and in 2020 begins an equity mutual fund SIP of ₹30,000. The end result is quite interesting as can be seen from the table below:

Rajesh’s Investment Nayan’s Investment
Monthly SIP Amount ₹15000 Monthly SIP Amount ₹30000
Starting year 2015 Starting year 2020
Ending year 2025 Ending year 2025
Annualized Return 16% Annualized Return 16%
Total Investment ₹18,00,000 Total Investment ₹18,00,000
Portfolio Value (in 2025) ₹44,47,073 Portfolio Value (in 2025) ₹27,67,480
Wealth Return Ratio 2.47 times Portfolio Value (in 2025) 1.54 times

The above table clearly demonstrates that even though both of them invested the same amount of money, Rajesh’s understanding of the compounding concept earned him a cool ₹16.79 lakhs more than Nayan. By starting early, Rajesh has the power of time value on his side. Rajesh has seen his wealth grow to ₹44.47 lakhs while Nayan’s wealth has grown to ₹27.67 lakhs. In fact, for Nayan to reach the same wealth level as Rajesh by 2025 he will have to invest ₹48,250 each month!
Since Rajesh has a 5 years’ head start, he had already created a corpus of ₹13.84 lakhs by the time Nayan had started his SIP. Time value has clearly worked in favour of Rajesh and against Nayan.

How Can You Start Investing Using The Compounding Effect?

The relationship between time value and wealth creation is dependent on the following three things:

  1. First, you need to start investing early.
  2. Second, get exposure to higher return assets such as equities.
  3. Third, consistently stick to your SIP plan with discipline no matter the disruptions and shocks in the market.

By consistently following these steps you can unlock the benefits of the power of compounding to create wealth. Investing in mutual funds with SIPs is a simple and easy way to reach your goals. Angel Bee allows you to map all your important future plans in one place and recommends you the best investment options that can help you achieve your dreams. Avail the benefits of compounding effect by investing in ELSS funds personalized according to your needs by downloading the Angel BEE app!

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