Three Silent Compounding Killers
It was none other than the great mind Albert Einstein who once said that “compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it”. Consider this: an investor who runs a Mutual Fund SIP of Rs. 25,000 per month for 15 years will likely end up accumulating close to 1.25 Crores of capital (assuming a modest long-term CAGR of 12%). On the other hand, an investor who pays a home loan EMI of around the same amount will, over the same period (assuming an 8.75% rate of interest) end up incurring nearly 28 lakhs of interest expenses, while paying off approximately 14 Lakhs of principal! In the first instance, it is you who reaps the benefits of compounding; in the second, it is the bank – at your expense.
Ironically, just a handful of investors will actually benefit from the magic of compounding, despite understanding its obvious payoffs. If you would like to end up on the winning side, avoid these all too prevalent three “compounding killer” habits.
The Action Bias
Most investors tend to grow impatient during times when markets do not provide satisfactory returns. Resultantly, they attempt to chop and change things around – booking losses here, taking some profits there… replacing a couple of ‘non- performers’, and so on and so forth. In doing so, investors often end up bearing transaction and taxation costs that set their returns back a few notches frequently. Additionally, there’s no guaranteeing that the changes will actually result in any improvement in future returns; too often, investors exit good investments that have been through a cyclical low, near the bottom of their cycles. Excessive churn is bound to take away from the compounding effect.
Risk Avoidance
Too many investors whose life stages and investment time horizons allow them to make high risk, high return investments, opt for the security of guaranteed returns of capital security instead. American Investor and Author Robert G Allen summed up the effect of too much risk aversion when he said - "How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case." Locking away your long-term moneys into Life Insurance plans that yield 4-6% or Fixed Deposits that fetch you 5%, will never allow you to benefit from compounding. Consider your retirement savings, for which you may have a time horizon of 25 to 30 years. Saving Rs. 20,000 per month in a Life Insurance plan that yields 6% per annum for 30 years will lead to a capital accumulation of 2 Crores. If the same amount was diverted to a more aggressive portfolio that earned 12% per annum on average, your fund value would have been a whopping 7 Crores.
Hyperbolic Discounting
“Hyperbolic Discounting”, the No. 1 enemy of your long term financial goals, is the natural human tendency to attach exponentially higher significance to short term payoffs, as compared to more important, long term payoffs. That explains why someone would dip into their child education fund to buy a new car, or liquidate their retirement corpus to pay for their daughter’s wedding. It also explains why many investors delay their savings continually. The next time you’re about to fall for this pernicious little trap, take a pause and consider that doing so would almost fully negate any compounding benefits that could have accrued on this corpus. An example will help illustrate this – say, you’ve accumulated Rs. 16 Lakhs over 5 years, as part of a 30-year retirement savings plan, but decide to pull out this money to buy a new car. This seemingly innocuous act would set your retirement fund back by an incredible 2.72 Crores! Long-term compounding works in mysterious ways, and it’s important that you understand it.
