Understanding the magic of compounding
Napoleon Hill, author of bestseller ‘Think and Grow Rich’ is often credited as saying that ‘Make your money work so hard for you; so that you do not have to work for it.’ Various books have been written on the art and science of making money based on more or less the same principle.
Mathematically speaking ‘Make money work for you’ is called compounding or simply compound interest. Albert Einstein was amazed by the power of compounding and called it the eighth wonder of the world.
Before we move on to identifying financial goals and how to achieve them it is important to understand the power of compounding and regular saving.
Regular saving in relatively safer financial instruments yielding moderate returns can work wonders over a long period of time. If a parent starts saving Rs 25 daily for their child from the day he or she is born for the next 25 years at a rate of 10% compounded annually, they would be able to gift the child an amount of Rs 9.25 lakh on his 25th birthday.
Apart from the money the amount will teach the child the advantage of savings. If he learns to save and invest in the same way as his parents and from the age of 25 years starts investing Rs 3,000 per month religiously in the same instrument earning 10% compounded annually he would be able to get an amount of Rs 1.14 crore at the time of his retirement (60 years).
Besides that, by increasing one’s SIP amount with rising income, an investor is investing more money, which may help in long term wealth creation with the added advantage of compounding. A top up facility can help his corpus grow and reach his financial goals faster.
Compounding works wonders over longer period
Compounding teaches us that it does not take too much money to save a decent amount. What is required is the discipline of regular saving and time on your side. Longer the time better will be the return.
Take the earlier example of the parent saving Rs 25 daily for a period of 25 years. In order to get the same amount in a span of five years they would have had to save Rs 400 every day. If the parents had saved Rs 150 every day for a period of 10 years they would have been able to save around Rs 9 lakh.
Another way of looking at the above example of retirement planning is that the amount of Rs 3,000 per month invested for 35 years, from the time he starts saving for till his retirement at the age of 60 yrs, will earn the person Rs 1.14 crore. This is equivalent to receiving Rs 38,000 per month for the next 25 years of his retired life, assuming that the entire amount of Rs 1.14 crore does not earn any more interest post his retirement.
Compounding and goal planning
Financial goal planning has to be on a steady and assumed return. Starting to save early in life prevents us from taking riskier bets. It is harder for your savings to catch up with your needs if you start investing later.
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