Take advantage of the power of compounding

Wed Oct 13, 2010 5:25pm IST

An elderly man walks in a park in Mumbai January 18, 2009. REUTERS/Arko Datta/Files

An elderly man walks in a park in Mumbai January 18, 2009.

Credit: Reuters/Arko Datta/Files

Related Topics

You will notice that the more you delay, the more you need to invest, hence it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

They say of trying to attain a weight loss goal, eat less and exercise more. Well, it’s no different when there is money involved. A parallel universal truth with regard to money is spend less, save more, for you to reach your ideal level of wealth. The earlier you start saving for your rainy day (read retirement) the richer you will be when it finally arrives.

In this context, you need not be a whiz in your attempt to make yourself financially secure for the future. You simply need to be consistent in saving a portion of your money and let it compound over time. The fascinating effect of compounding gathers up momentum over longer periods of time and becomes an avalanche of wealth.

HOW DOES COMPOUNDING WORK?

When you save Rs.100 and get an annual interest of 10%, you will have Rs.110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs.110, which will then leave you with Rs.121. The next year, interest will be calculated on Rs.121 at 10% and so on. In time, these savings will grow exponentially.

There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double.

So, if you invest Rs.100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 = 7.2 years as the approximate time frame required for the investment to become Rs.200. If you equate the same to a larger amount of Rs.1L in approximately 7 years, it would grow to 2L.

Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

FORTUNE FAVOURS THE EARLY BIRD!

Compounding interest is like wine, yields better results when money is saved over longer durations. So, if you are planning to save crores for your retirement funds, then start as early as possible, with your first salary or at least by 25 years of age. So, when you retire at the age of 60, you will be sitting on a comfortable pile of money to lead the rest of your life in style.

If you set aside a sum of say Rs.5,000 every month from the age of 25, at a return interest rate of 10%, in 60 years you will have with you funds worth about a crore and more. However, if you start at 40 with the same amount and return rate of interest, the retirement fund will amount to only around 33 L. That is a huge difference, the 40 year old individual would need to invest several multiples of Rs.5000 to be able to catch up!

Here is a comparative chart of the approximate retirement funds an individual can lay claim to depending on the age at which he starts saving. Let us assume the individual plans to invest Rs.10,000 every year at a return interest rate of 10%. You will realize from the chart that starting early counts a lot!

Age at which investment begins – 20; Retirement fund – 49L

Age at which investment begins – 25; Retirement fund – 30L

Age at which investment begins – 30; Retirement fund – 18L

Age at which investment begins – 35; Retirement fund – 11L

Age at which investment begins – 40; Retirement fund – 6L

You will notice from the above comparison, that even a matter of five years can make a huge dent on how much you retire with.

You could choose to start saving when you are much older and still meet the target retirement fund of 49L, saved by an individual who started investing from the age of 20. However, you will need to increase the amount of money you invest to make up for the lost time. This could be a strain on your budget, as you may have to set aside a significant amount of money to reach your goal. To illustrate, let’s see how much more you would need to invest and at what age, for you reach a target of 49L by the time you are 60 yrs old. Here is a comparison of the approximate increase in the amounts of money you need to shell out every year to reach your target.

Age at which investment begins – 20; Difference in funds invested – 10,000

Age at which investment begins – 25; Difference in funds invested – 16,500

Age at which investment begins – 30; Difference in funds invested – 27,000

Age at which investment begins – 35; Difference in funds invested – 45,000

Age at which investment begins – 40; Difference in funds invested – 78,000

You will notice that the more you delay, the more you need to invest, hence it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

All you need to reap the advantage of compounding interest and save up a significant retirement fund is to invest time, consistency, patience, and savings to obtain a financially secure future, when you need it the most.

DISCLAIMER

Copyright 2010 BankBazaar.com. All rights reserved.

This tool/content is provided by BankBazaar.com and not by Reuters. The content may not be copied, broadcast, downloaded and stored (in any medium), transmitted, adapted or changed in any way whatsoever without the prior written permission of BankBazaar.com.

BankBazaar.com is an online marketplace where you can instantly get the lowest loan rates, compare and apply online for your personal loan (click here), home loan (click here), car loan (click here), credit card (click here) from India's leading banks and NBFCs.

FILED UNDER:
We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
Comments (2)
manavs wrote:
These guys have to be the worst financial advisers ever. After all, what kind of a ‘finance’ adviser doesn’t re-check and cross check his numbers and their relevance. First off, he’s talking about retiring 60 years from the date of investment (SIXTY YEARS??!!!! Are you nuts????)…so when does one start investing? From the day of being born?!
Secondly, he quotes ‘Rule of 72′ and then goes on to say that the investment will multiply ’six’ times in ’sixty years’. Have you totally lost it? @ 10 % compounding, the investment of one lac will turn to 32 lacs in 36 years. Just check your numbers before you post them for the world to see. @ Reuters:- Shame on you guys…Yes, there is a disclaimer, but still, it is your website. Have you run out of credible financial advisers to have to scrape the bottom of the barrel?

Oct 20, 2010 10:40am IST  --  Report as abuse
kpvidya1999 wrote:
The effect of the insidious gov’t manipulation called INFLATION is not taken into account in the above calculations. I would have been better off if I had not saved in cash form as it is now worthless. I followed this method from the first day of job and I have savings cash which has a less purchasing power. I should have listened to my Grandmother who used to convert any bonus / salary hike to buy land or Gold. I followed the wrong advice and still have to work. This theory is good for people who will hand over their hard work to GOV’T which cheats by inflation. People must work hard and smartly and put every rupee they earn to work. Read RICH DAD POOR DAD, study expert advice, see trends, get a good financial adviser who does not need money .. and try your own methods.

Nov 11, 2010 8:24am IST  --  Report as abuse
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.

  • Most Popular
  • Most Shared

End of Planning Commission