One of the most common instructions you will get to hear in personal financial planning is that you need to start investing early so that you can stay invested long enough. So, what exactly are the benefits of investing early in life and why is it essential for investors to understand the importance of investing early in life. The logic is something like this! When you start early you give more time for your corpus to generate returns. When you give more time for your corpus to generate returns you effectively give more time for your returns to generate more returns. In technical parlance this is called the power of compounding which shows that even with very humble investments you can create a huge corpus over a longer time frame. To understand this in the right perspective you need to understand why you should start investing early and more importantly the trade-off of investing early vs late.
Let us assume two situations. In the first situations a lump-sum is invested in equity funds and it is allowed to grow for different periods of time. In the second situation we will assume that an investor does a Systematic Investment Plan (SIP) on a diversified equity fund over different periods of time. Let us see how it works in practice..
Power of compounding when you invest a lump-sum..
In the illustration below we are assuming 5 persons who are all due to retire in 2020 at the age of 55. Each of them has invested a corpus of Rs.1 lakh but the difference is that they have invested this money at different ages ranging from the age of 20 to the age of 40. A person who invested Rs.1 lakh at the age of 20 has 35 years to grow his corpus while the person who invested Rs.1 lakh at the age of 40 has just 15 years to grow his corpus.
Rs.1,00,000 invested at 14% for different time periodsParticulars15 years20 years25 years30 years35 yearsAccumulationRs.7,13,793Rs.13,74,349Rs.26,46,192Rs.50,95,016Rs.98,10,018Wealth Ratio7.13 times13.74 times26.46 times50.95 times98.10 times
The table above clearly illustrates the benefits of starting early. The individual who invested a lump-sum at the age of 40 could hold the investment for 15 years and the corpus grew to Rs.7.13 lakhs (a wealth ratio of 7.13 times). On the other hand the person who invested a lump-sum at the age of 20 could hold the investment for 35 years and the corpus grew to Rs.98.10 lakhs (a wealth ratio of 98.1 times). That is the kind of difference that starting early makes. To understand the above disparity in wealth created let us understand the Rule of 72 in finance. The Rule of 72 says that your corpus doubles in (72/yield) number of years. In the above case since the yield is 14%, the corpus doubles approximately every 5 years. That is why you will see that at every gap of 5 years the corpus nearly doubles. That is how the power of compounding works in your favour if you start early.
Lump-sum is fine, but what about SIPs..
In the first case we have seen the outcome of wealth creation when the lump-sum corpus is held for a longer period. For most regular savers and investors, a SIP is more relevant. Nowadays, most equity investors prefer the SIP route since it synchronizes with the regular monthly income inflows of the individual. Let us take an alternate illustration and see how the same 5 people would fare if they had done a SIP of Rs.10,000 per month on the same fund at the same yield for the same number of years.
SIP of Rs.10,000 per month invested at 14% for different time periodsParticulars15 years20 years25 years30 years35 yearsInvestmentRs.18,00,000Rs.24,00,000Rs.30,00,000Rs.36,00,000Rs.42,00,000AccumulationRs.61,28,538Rs.1,31,63,463Rs.2,72,72,777Rs.5,55,70,556Rs.11,23,24,859Wealth Ratio3.40 times5.48 times9.09 times15.44 times26.74 times
As can be seen in the above case, if you did a SIP of Rs.10,000 for 15 years your wealth ratio is just 3.40 times whereas if you did the SIP for 35 years then your wealth ratio is 26.74 times. Why do investments work more when you start early? There are 5 reasons..
5 Reasons why starting early helps you accumulate a bigger corpus..
When you are invested over a longer period of time, the cycles in the market and in business tend to get smoothened over a period of time. This overcomes the short term volatility and provides smoother returns over the longer run.
The power of compounding works best when you are invested for a longer term. In fact, you will find the wealth ratio higher in case of lump-sum investment as the holding period is longer in each case compared to the SIP.
The longer period allows fund managers also to show steady CAGR performance and even in practical situations this results in better returns for investors as their holding period goes longer
When you are invested in a growth plan, remember that over the longer term the principal and the intermediate returns are being reinvested. This effect becomes more pronounced as the holding period becomes longer
There is a tipping point that happens around 15 years. After that the wealth accumulation becomes a lot more rapid. That is how the power of compounding works in your favour.
Why is lump-sum generating relatively more wealth..
The reason is simple. You are making the investment upfront so it gets a full 35 years to grow. That is why it is generating 98 times wealth over 35 years as compared to the SIP which generates about 26.7 times wealth over 35 years. The moral of the story is that to get the full benefits of starting early, invest in a combination of SIPs, which is more pragmatic, and lump-sum, which is more productive in the long run. That is the message!