My Tips Towards Wealthy

Thursday, September 23, 2010

The Extraordinary Power of Compound Interest

What is the best way to ensure your financial success ?

As per Burton Malkiel in The Random Walk Guide to Investing. - “The amount of capital you start with is not nearly as important as getting started early,”. He also mention that  "Procrastination is the natural assassin of opportunity."  


Even modest returns can generate real wealth given enough time and dedication. That is the miracle of compound interest. Hearing this many questions come to our mind

1. Why is it important to start early ?
2. How come a mere 8% annual return from PPF account help us to build a retirement corpus ?



Why is it important to start early ?
Let me explain with an example, a 20-year old Emma makes a one time Rs50,000 contribution to PPF and earns 8% annual return. After 40 years [at the age of 60], that Rs 50,000 will grow to Rs 11,73,124. But if she wait till the age of 30 to make her single investment, that Rs 50,000 would only grow to Rs 5,43,383.

How much is the loss?
Rs 11,73,124 - Rs 5,43,383 = Rs 6,29,741

Hope you got the maths. Thats the Magic of Compound Interest. Here TIME is the primary ingredient which does the magic of Compounding.

How come a mere 8% annual return from PPF account help us to build a retirement corpus ?
 Just now we have seen the magic of compounding. Now there is one more methods to make compounding more powerful, ie Systematic investment. If Emma can contribute Rs 50,000 annually to her PPF account for 40 years with 8% return, her retirement savings will be Rs 1,52,12,176. [ie more than 1.5 crore rupees].

Here she just invest 20 lakhs
ie Rs 50,000 * 40 = 20,00,000
 and got above 1.5 crore rupees. This is more than 13 times the amount she invested. From this maths its pretty clear that we can create a retirement corpus even with 8% return from PPF.

Its worth to mention that this 8% return may not be sufficient in the long run. To build retirement corpus its always better to go behind equities. Indian equities used to give an average return of 18-20% return in the long run [>5 years]

The cost of waiting one year
It’s human nature to procrastinate. We used to tell ourself "I can start saving next year”, “I don’t have time to open a PPF - I’ll do it later.” But the costs of delaying may be enormous. Even one year makes a significant difference. Here’s a chart which illustrate the cost of procrastination. Again, we’re using 20-year-old Emma as a basis.




If Emma makes Rs50,000 annual contributions to PPF, and she earns an 8% return, she’ll have Rs1,52,12,176 saved at retirement. But if she waits even five years, her savings would be Rs 1,01,53,516 which is a loss of more than 50 lakh rupees!

Summary
To make compounding work for you:
  • Start early. The earlier you start, the more time compounding can do magic in favor of you, and the wealthier you can become. The next best thing to starting early is to start now.
  • Make regular investments. Don’t procrastinate. Remain disciplined, and make saving for retirement a habit and priority in your life. When ever you got any bonus or increment try to increase your contributions.
  • Be patient. Do not touch this money. Compounding only works if you allow your investment to grow. Time is the key to do this magic. Initially we may see only small returns, but persevere. Most of the magic comes at the very end. Compound interest will create a snowball of money
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    2 comments:

    1. very useful, everyone must also note to transfer their pf account while changing jobs , most of them withdraw the entire amount this is a major drawback for wealth creation.

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