Case 1: You invest Rs 1,000 per month for 15 years and earn a return of 12% p.a.
Case 2: You invest Rs 2,000 per month for 15 years and earn a return of 10% p.a.
In which case, will you end up with a larger corpus?
Let’s find out.
Do note the rate of return is higher in the first case while the amount invested is higher in the second case.
In case 1, you will end up with Rs 4.75 lacs.
In case 2, you will end up with Rs 8.03 lacs.
Case 3: You invest Rs 2,000 per month for 15 years and earn a return of 8% p.a.
You will end up with Rs 6.79 lacs, still way higher than case 1.
Case 4: You invest Rs 2,000 per month for 15 years and earn a return of 6% p.a.
You still end up with Rs 5.76 lacs. Still better than case 1.
Case 5: You do nothing for the first 5 years but invest Rs 5,000 per month for the next 10 years and earn a return of 10% per annum.
You end up with Rs 10.07 lacs.
Equation of Compounding
When we talk about compounding and the merits of long term investing, quite a few of us focus mostly on the annual returns earned and investment horizon. However, compounding is much more than that.
We need to review the equation of compounding
Amount = P(1+r)^n
As you can see, return (r) is not the only variable. Principal (P) and the number of years (n) also play a part.
And that’s what happened in cases 2,3,4 and 5. You simply invested a much larger amount and more than made up for the lower returns earned. In case 5, you invested for only 10 years (and not 15) and still ended up with a higher corpus.
The problem is that the most of us limit ourselves to “r” and and invest a good part of energy in chasing the best mutual fund to invest in. Believe me it is a never-ending race.
But what about the investment amount? Is that not important?
From the examples discussed, the amount invested is clearly important.
You may have the fastest car on the planet but it can’t run without fuel. Amount invested is akin to the car fuel.
I talk to many investors and clients who feel that figuring out the best returning investment will somehow unleash magic and create huge wealth for them. Far from it.
Figuring out a good investment and investing in it for the long term is certainly important. However, you need to invest a meaningful amount too.
Investing is not similar to participating in nursery drawing competition, where primary aim is to encourage participation. When it comes to investing, participation alone is not enough, meaningful (and purposeful) participation is.
I know people with investible surplus of over Rs 50,000 per month and they invest Rs 2,500 per month by way of SIPs in equity funds.
By the way, there is another extreme too. I know people who want to withdraw EPF and sell their house to invest in equities. Such people are gamblers, not investors. Less I talk about them, the better.
In a portfolio of Rs 2 crores where equity portion is only Rs 5 lacs, equity will not make a meaningful impact on your portfolio (even if you hit a jackpot).
By the way, I am not saying everyone should invest in equities. Your level of participation should depend on your risk appetite and risk taking ability. However, if you believe equities are the right product for you, invest amounts so that it can make an impact on your overall portfolio.
Amount that you invest is important.
What does this tell you?
Returns and the investment horizon are not the only parameters when it comes to compounding. Amount invested is critical too.
While saving for a goal, it is better to have lower return expectations and invest more. After all, you don’t control the returns you earn. However, you can control (to quite an extent) how much you invest.
Financial planning is not about earning the best returns. It is about planning investments in a manner that you have the money when you need it. By investing more, you are also building yourself a buffer.
It is important to start early. However, it is equally important that your contributions are meaningful. Therefore, for young earners, it may be a good choice to focus more on increasing their investment (earning) ability (than figuring out the best yielding investments).
I have covered this aspect in another post of investment planning. You can read the post here.
You need to review your investments as your income grows. For instance, if you are investing through SIPs, try to increase your monthly investments every year.
If you are averse to investing in equity, you can build an equally large corpus or even bigger corpus simply by investing more in conservative investment i.e. you can make up for the potentially lower returns by simply investing more. And you can do that without taking much risk.
I discussed in another post how much you need to invest per month for various starting ages and varying levels of return to accumulate Rs 1 crore by the time you retire at the age of 60.
What I am not saying?
I am not saying Rs 1,000 per month is less. All I am saying is that you need to invest more if possible.
I am not saying annual returns are not important. Make no mistake, returns are important.
I am not undermining the importance of starting early either.
Investing is a lot about discipline. By starting early, you have more time to learn, understand and experience how capital markets work. However, as I mentioned above, the greater focus should be on investing more.
But the amount invested is important too.
The Freakish Strong Base by Morgan Housel