Magic of compounding: How does the investment time horizon impact the final corpus?

The legendary investor Warren Buffet once said: "Our favourite holding period is forever." In this quote, he emphasises the importance of the investment time horizon. As per a report published on the NSE website, when you invest for the long term, the instances of you earning negative returns on a daily rolling basis go down as the investment time horizon goes higher.

As per the report, when the investment time horizon was five years, there were only 0.1% total instances of negative returns on a daily rolling basis. Similarly, for an investment time horizon of 7 and 10 years, there were 0% total instances of negative returns.

In this article, we will understand why you should always invest for the long term and how it impacts the final corpus that you will accumulate.

Impact of investment time horizon on the final corpus

The investment time horizon is one of the pillars of compounding, the others being the amount invested, the expected rate of return, and the compounding frequency. Generally, the longer your investment time horizon, the higher the amount you will accumulate, other things being the same. Let us take an example to understand the impact of the investment time horizon on the final corpus you will accumulate.

Kavita, Jasmine, and Isha are investing for their retirement in the following manner:

1. Kavita starts a SIP with Rs. 10,000/month for 10 years in an equity mutual fund and is expecting a 12% CAGR
2. Jasmine starts a SIP with Rs. 10,000/month for 15 years in an equity mutual fund and is expecting a 12% CAGR
3. Isha starts a SIP with Rs. 10,000/month for 20 years in an equity mutual fund and is expecting a 12% CAGR

Let us see how much amount they will accumulate.

As seen in the above table,

1. Isha will accumulate the highest amount of Rs. 99.91 lakhs as her investment time horizon is the longest of 20 years.
2. Jasmine will accumulate Rs. 50.46 lakhs as her investment time horizon is 15 years.
3. Kavita will accumulate the lowest amount of Rs. 23.23 lakhs as her investment time horizon is the shortest of 10 years.

As seen in the above table, the longer your investment time horizon, the higher will be the corpus you will accumulate, other things being the same.

Nifty 50 Index returns based on the investment time horizon

At the start of the article, we saw how a long investment time horizon reduces the probability of negative returns on a daily rolling basis. Let us look at how the Nifty 50 Index returns have fared over different investment horizons on a daily rolling basis.

Nifty 50 Index returns on a daily rolling basis

Source: www.nseindia.com

Note: The above data is as of 15th December 2021.

As seen in the above table, on a daily rolling basis:

1. For an investment time horizon of 7 years and 10 years, the returns were higher than 5% CAGR
2. For an investment time horizon of 7 years, 40.3% of the time, the returns were in the 10-15% CAGR, and 39.8% of the time, the returns were above 15% CAGR, which are good returns.
3. For an investment time horizon of 10 years, 32.1% of the time, the returns were in the 10-15% CAGR, and 47.9% of the time, the returns were above 15% CAGR, which are good returns.

So, the above data shows; the higher your investment time horizon, the higher the probability of higher returns you will make.

Classification of financial goals based on the time horizon

In the above section, we have seen how investing for the long term can help you earn high returns with the magic of compounding. However, you cannot invest in all financial goals for the long term. Based on the investment time horizon, you can classify financial goals into the following three categories:

Short-term financial goals: These can include goals that need to be achieved within 3 years. Some examples of these goals include building and maintaining an emergency fund, buying life insurance for the family bread earner(s), buying health insurance for the entire family, creating an annual vacation fund, etc.

For short-term financial goals, debt funds and other fixed-income instruments are a better choice than equity funds (as they are volatile and vulnerable to sharp falls in the short term).

Medium-term financial goals: These can include goals that need to be achieved within 3-7 years. Some examples of these goals involve accumulating a fund for a house down payment, purchasing a car, starting a business, repaying a home loan, etc.

For medium-term financial goals, hybrid mutual funds are a better choice as they provide exposure to a mix of equities and fixed income. Equities have the potential to create wealth, and fixed income can provide stability to the overall portfolio when equity markets are falling.

Long-term financial goals: These can include goals with a time horizon of beyond 7 years. Some examples of these goals include building a fund for a child's higher education and marriage, a fund for one's own and spouse's retirement, etc.

For long-term financial goals, equity mutual funds are a better choice as they have the potential to give high returns in the long run, as seen in the table in the earlier section.

Classify your financial goals based on investment time horizon and invest accordingly

The general rule is higher the investment time horizon; the higher will be the returns, other things being the same. However, some financial goals need to be accomplished in the short to medium term. Hence, you should classify your financial goals into short, medium, and long-term goals. Based on the investment time horizon, select the appropriate financial products and invest accordingly.

While a longer investment time horizon can give you higher returns, you must be patient with your investments and give time for the magic of compounding to work wonders. The quote from well-known investor Philip Fisher justifies patience in long-term investing: 'The big profits I have made were through very long planning, waiting and watching."

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.