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  1. Understand the power of compounding – Why starting early is the key to building wealth

Understand the power of compounding – Why starting early is the key to building wealth

Early investors always gain from the power of compounding. Investing in a systematic investment plan in equity mutual fund, PPF or NPS at an early stage can help the investor to accumulate a large corpus just by the power of compounding.

By: | New Delhi | Published: August 1, 2018 12:08 AM
Understand the power of compounding – Why starting early is the key to building wealth (Illustration: shyam)

Many individuals wait endlessly for the right time to decide on investments. As a result, they lose out on the compounding benefits and the opportunity cost rises.

Early investors can afford to invest in equities or risky assets, which fluctuate widely in the short term but provide better returns in the long term. Since you have time with you, you can afford to keep your money invested to enjoy higher returns. The thumb rule of investing in equities is 100 minus one’s age. For instance, a 25-year-old should invest 75% in equities and 25% in debt or debt-oriented funds. Similarly, a 35-year-old person should split it as 65-35.

Compounding benefits

Early investors always gain from the power of compounding. Investing in a systematic investment plan (SIP) in equity mutual fund, Public Provident Fund (PPF) or National Pension Scheme (NPS) at an early stage can help the investor to accumulate a large corpus just by the power of compounding. In mutual funds, investing via SIP early in age can help accumulate long-term wealth. The magic of compounding means earnings on the past earnings plus the principal amount. To make compounding work in your favour, invest in those financial assets which give higher returns.

If an investor invests Rs 1,000 every month in SIP, the amount will become Rs 1,64,000 in 10 years at a very conservative 8% annual rate of return. If the investor invests for another 10 years, then the money will grow to Rs 4,47,000. So, this is the gain for an investor due to the power of compounding.

Insurance premium

Insurance premium grows with age. In medical insurance, premium rises significantly because of age. Taking medical insurance at a young age ensures that your premium is lower and you will gradually increase when your hit age brackets such as 35, 40, 45, 50, etc. On the other hand, if a policy is taken at an old age, the premium will be high as insurance companies fear high claims ratio at old age. For instance, a health insurance cover of Rs 3 lakh can be bought for around Rs 4,000 per year for a person who is 25 years of age while the same cover will cost around Rs 8,000 for a 35-year-old.

In life insurance, premium for a `1 crore term plan (online) from a private insurer will be around `8,400 for a 30-year-old. The premium for a same term plan will be Rs 10,500 when one is 35 and `17,500 when one is 45. The thumb rule for a term plan is that the sum assured should be 10 times one’s annual income.

Wider choice in NPS

In National Pension Scheme, young investors can invest up to 75% in equity in the aggressive life cycle fund. The Pension Fund Regulatory and Development Authority (PFRDA) has introduced two more life cycle funds apart from the initial one—moderate life cycle fund (with 50% equity cap). The two are aggressive life cycle funds with 75% equity cap and conservative life cycle fund with 25% equity cap.

In the aggressive life cycle fund, the equity allocation is up to 75% till the age of 35 years, 51% in age 41, comes down to 26% when the subscriber turns 48 and 15% when he is 55. In moderate life cycle fund, subscribers till the age of 35 can invest up to 50% in equity. The equity component falls with the increase in age of the subscriber and it becomes 10% when the subscriber is 55.

In conservative life cycle fund, equity allocation is up to 25% till the age of 35 and comes down to 5% by the time the subscriber is 55. These life cycle funds are available to private sector subscribers. For government employees, the equity limit is still capped at 15%.

A CRISIL study on returns of life cycle fund having equity cap at 25%, 50% and 75% and under various market scenarios, says the returns given by life cycle fund having equity cap at 75% is maximum as compared with the other two life cycle funds. This is the power of compounding.

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