January 22, 2017

The Truth About Compounding

If you’ve ever flipped through mutual fund literature on SIPs, the chances are that you would have come across references to “the power of compounding” as one of the benefits of investing in SIPs.  If you’ve ever had the experience of listening to mutual fund salespeople and/or financial advisors talk about the virtues of SIPs, you would have likely heard them use this catchphrase as well.  For added impact, some of them may have quoted Albert Einstein as having called compound interest the “eighth wonder of the world”.

Fact is, there is no record of Einstein ever having praised compound interest (see here and here).  Nonetheless, compounding is, without a doubt, a powerful force that one should take advantage of.  But to do so, one has to have a clear, conceptual understanding.  For instance, one should know that contrary to what many fund houses and advisors say, doing a SIP, in itself, does not assure us benefits from “the power of compounding”.  This post is for those of us who would like to get to the truth about compounding.

Compound interest is the interest that you earn, not just on the amount that you invest, but also on that interest.  As an example, consider a bank deposit (or any other fixed income instrument) in which the interest is automatically reinvested and paid on maturity.   In such a deposit, on maturity, along with your principal, you get interest on your principal, as well as interest on the interest that is reinvested.  It is this interest on interest that is the additional benefit of compounding.  The question: is this really worth such a fuss? 

Depending on the rate of interest and the tenure of the deposit, the interest on interest can make up a significant part of the overall interest.  In fact, it may well make up the majority share of the overall interest that you receive on maturity.  Here are some numbers that illustrate this.

The table below shows the share of interest on interest of the overall interest from a hypothetical recurring deposit in which one makes a fixed annual payment and receive an annual interest of 8% pa that is reinvested.

Rate: 8% pa Share of Overall Interest
Tenure of Deposit Interest on Principal Interest on Interest
5 years 90% 10%
10 years 78% 22%
15 years 67% 33%
20 years 57% 43%
30 years 40% 60%

This table below shows the share of interest on interest of the overall interest from a hypothetical recurring deposit in which one makes a fixed annual payment and receive an annual interest of 12% pa that is reinvested.

Rate: 12% pa Share of Overall Interest
Tenure of Deposit Interest on Principal Interest on Interest
5 years 85% 15%
10 years 68% 32%
15 years 54% 46%
20 years 42% 58%
30 years 23% 77%

In the real world, it may be unlikely to get a quality deposit that pays 12% pa, or even one that has a tenure 20 or 30 years.  So do these numbers have any practical relevance?  And what about mutual funds? Since they don’t pay fixed interest, are these numbers of any use to mutual fund investors?

The concept of compounding is not just restricted to interest.  It also applies to dividends, and even gains.  And if you substitute the tenure of deposit with the number of years of investing that you have left (until retirement), and the rate of interest with the rate of return that you expect to earn on your overall portfolio, a clearer picture of the real-life implications will emerge.  So let’s say that you have 30 years of investing left and you expect to earn 8% pa on your investments.  That would mean that roughly 60% of your potential gains will be on account of compounding.  And if you earn 12% pa on your investments, then, roughly speaking, compounding will account for a whopping 77% of your gains!  Now, that is what the power of compounding is all about.

Bear in mind, these calculations are approximations to facilitate understanding.  More importantly, these hold good only if you reinvest your interest/ dividends/ gainsIf you choose to take dividends and spend that money then you will lose out on the gains on account of compounding.  In effect, this means that to tap into the power of compounding, we should avoid the temptation to encash dividends/ gains and spend that money.  This would apply to all investors, regardless of whether they do a SIP or a one-off investment. 

I must also point out that just as gains are compounded, so are losses.  In other words, for all its power, compounding is not a cure for poor investment choices. 

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