Photo: iStock
Photo: iStock

Make compounding an integral part of your investment strategy

  • There are 2 essential elements that make compounding work. The first is to give investments the time to build and the second is to have the discipline to remain invested.
  • The benefits of compounding are magnified when the return on investment is higher as in the case of long-term equity investing

When investing for your child, you can let the power of compounding come into play and boost your investments. But to do that, you would have to ensure that you start early on so that your investments have enough time to reap the benefits of compounding.

Compounding is not just a mathematical idea but one that has consequences for your money life too. When you save and make an investment, the money earns returns and then this return also begins to earn returns automatically, accelerating the total returns earned. There are two essential elements that make compounding work. The first is to give investments the time to build and the second is to have the discipline to remain invested. How much you invest is less important than how long you invest to make compounding work for you.

Start early

Don’t wait to accumulate a large sum before you begin investing. When you are saving for your children, there is a clear start date that you can peg your investments to—the day of the child’s birth.

If you started investing just 2,000 per month when the child is born and continue to do so till the child is 18 when you have to meet their education expenses, you would have accumulated a corpus of 15 lakh, assuming the investment earned a return of 12%. Of this 15 lakh, your contribution would be just 4.32 lakh.

In comparison, if you delayed the start of investments till the child was five years of age, the corpus available when she is 18 would be half at just 7.5 lakh, if you continue investing the same amount and assume the same rate of return on the investment. You would have to double your contribution to be able to reach the same corpus of 15 lakh when she turns 18. This is why how early you start investing matters more than how much you invest.

Continue the cycle

While starting early is important, make sure that you don’t break the compounding cycle by withdrawing money early. Early exit or stopping periodic investments can affect the compounding benefits. In the previous example, let us say you withdraw 2 lakh in the 10th year and don’t replenish the fund, then the final corpus will be lower at 10 lakh. The impact on the final corpus is more than 2 lakh because of the compounding benefits you lost.

Clearly earmark the investments for the child’s future so that you can resist the temptation to withdraw in the interim. Even if there is an emergency and you do withdraw, make sure that you replenish as quickly as possible to mitigate the impact of loss of compounding.

Boost the returns

The benefits of compounding are magnified when the return on investment is higher as in the case of long-term equity investing. For example, in the above example, if the investment earned 8% instead of 12% the corpus would be only 9.7 lakh instead of 15 lakh at 12%. Since the child’s need for funds will typically be 10 or more years away, you can invest in equity products.

Another way to give a boost to your corpus is by increasing the investment amount each year, say, on the birthday of the child. By increasing the amount by 500 for each year, the corpus, in the same example, more than doubles to 36 lakh. The benefit of compounding is enhanced on the higher investments.

Put systems in place to make sure that you stay on track on getting to your goal. Most investments come with features that make it easier for compounding to work. the growth option in mutual funds allows the returns to remain invested and continue to earn returns in the future. Bonds and deposits have the cumulative option that reinvests the interest earned into the same investment and earns returns. The maturity value will have the compounded returns over the period. Have the discipline to reinvest the proceeds as soon as investments mature so that your money keeps working for you.

We tend to overlook compounding because it takes time to show its benefits. But once you understand how it works, make it an integral part of your investment strategy.

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