The earlier in life you start investing, the greater will be the wealth you create. Not only that, if you start investing early, you will need to invest a lower amount to fulfill your life goals - the reason for this
Compounding’ – what is it and how does it help
When you invest in a financial instrument that offers interest, you are usually asked whether you want the interest to be paid out to you or if you want to take a ‘cumulative’ option. In case of the latter, i.e. the ‘cumulative’ option, the interest remains invested in the financial instrument, which, in turn, earns you further interest. As a result, the total amount of interest you earn due to the ‘cumulative’ option is higher than when the interest is paid out. This concept of having your interest reinvested in order to earn more interest is called ‘compounding’. In other words, compounding means increasing your investment income by letting your income remain invested instead of withdrawing it.
Compounding can be thought of as one of the most compelling reasons to start investing early. Let’s consider an example. Jay and you invested Rs 60,000 each over a period of 10 years. But you both do it slightly differently.
You started investing from Year 1 while Jay started investing from Year 5. You invested Rs 500 per month which sums up to Rs 6000 every year, while Jay started investing only in the 6th year and he invested Rs 1,000 per month which sums up to Rs 12,000. Both of you earned 12% interest annually. So how do you think the investments will pan out?
Click here to see the calculation.
From the calculations, you can see that at the end of the period, you have made a profit of Rs 55,019, as compared to Jay who has only made Rs 21,670 even though both of you invested the same amount of money. That’s because you started investing early and benefited from the power of compounding. You will also notice that the investment income increases over time because of each previous period’s income being retained, thereby increasing the capital invested.
This is why it’s best to start investing early and to keep the returns cumulatively
invested.
How much should you invest?
Your financial goals should ideally determine how much money you need to invest. As a general rule, keep 6 months’ of expenses saved in your bank account to deal with any emergencies and to fulfill your short term needs such as buying a new car, taking a holiday, etc. To meet your long term financial goals such as a wedding, buying a home, retirement, etc., you need to invest smartly, and for a longer duration.
In order to figure out how much to invest, you must first realistically estimate how much the goal will cost you in the future; to do this, you must keep inflation in mind. Calculate how much you need to invest each month to get to that amount. Even if you start by investing a nominal amount, for example Rs 500 per month, you are still taking the first steps towards fulfilling your financial goals.
If you receive a windfall bonus, or a lump sum, then in order to take advantage of compounding, invest it as soon as possible. However, make your investment wisely after studying various investment options.
Consult an investment advisor to help you make your investment.
Key Takeaways
- Investing early helps you build larger wealth reserves since you benefit from the power of compounding over a longer period of time.
2. Due to compounding, a person who has invested early will accumulate more wealth than another person who has invested later in life even if both have invested the same amount of money.
3. To fulfill a financial goal that will arise in future, figure out how much the goal will cost when it is due for fulfillment; take into account inflation.
Disclaimer: All Mutual Fund investors have to go through a one-time KYC (Know Your Customer) process. Investors should deal only with Registered Mutual Funds (‘RMF’). For more info on KYC, RMF & procedure to lodge/redress complaints, visit dspim.com/IEID. This is an investor education & awareness initiative by DSP Mutual Fund.
