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Business News/ Money / Personal-finance/  DYK: Compounding also depends on time and return expectations
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DYK: Compounding also depends on time and return expectations

Compounding by itself it may not maximise wealth; it needs the support of two variablestime you remain invested and the return expectation

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Long-term investing relies on the concept of compounding for wealth creation. Compounding essentially refers to multiplying earnings by reinvesting them over a period of time. By itself it may not maximise wealth; it needs the support of two variables—time you remain invested and the return expectation. Here is how these two can be utilised to your advantage.

What is compounding?

Let’s say you invest 1 lakh in a fixed deposit for five years at an annual interest of 8.5%. If the terms of the deposit specify simple interest, it means that each year 8,500 interest amount will get credited to your account, and at the end of five years, you will receive your principle plus interest—a total of 1,42,500. If the interest was compounded annually, at the end of the first year, you would receive 8,500 as interest. For the next year, interest would be calculated on 1,08,500 at 8.5%, which would amount to 9,222.50. At the end of five years, you will receive a total of 1,50,365.7.

Hence, compounding means earning on earnings.

Time, return expectations

The longer you remain invested, the higher is the benefit of compounding. Let’s increase the time period of the above example to 10 years. On a simple interest basis, in 10 years you would have 85,000 as interest, and the total amount you would receive at the end would be 1,85,000. On a compounded interest basis, however, the total amount will increase to 2,26,098.34.

At the end of five years, compounding interest meant you received 5.5% more than what you would on a simple interest basis. But if you remain invested for 10 years, you get 22% more. This is because the amount on which interest is paid increases every year.

If you want to maximise wealth creation, start investing early. Compounding earnings is possible across assets. For example, you can invest in an equity stock or mutual fund and the change in your earnings growth is thanks to compounding. Let’s say the price of a stock is 150. After a year, the price is 15% higher at 172.50, and in two years, by another 15%. Your gains will be on the enhanced price of 172.50 rather than the original price of 150.

You can manage your return expectation by managing asset allocation. If you invest your long-term funds in fixed income instruments, returns get compounded at an average 8-8.5%. So, in 10 years, 1 lakh can grow to about 2,15,000-2,26,000. Now if you choose to invest half of the money in equity-oriented investments and half in fixed income instruments, assuming an annualised return of around 12% in equity, after 10 years, the amount can grow to 2,60,000-2,65,000. Hence, your choice of assets can influence the overall long-term return.

While fixed income securities have a fixed payout, equity earnings, though volatile, show considerably higher returns in the long run.

Choose assets based on your long-term goals and on the amount of risk you are comfortable with.

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Published: 20 Apr 2016, 06:03 PM IST
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