Benefits of Compounding
Albert Einstein famously said ‘compound interest rate is the eighth wonder of the world. He who understands it, earns it, he who doesn’t pays it’. What happens when you push a snowball down a hill? it continues to pick up snow. When it reaches down the bottom of the hill it becomes a giant snow boulder. The snowball compounds during its travel, the bigger it gets the more snow it collects with each revolution. The snowball effect is an apt metaphor for compounding which illumines on the role of time acting as a catalyst to compound. Warren Buffet compounded wealth at the rate of 22% per annum for 70 years. When Buffet was 60 years old when his net worth was $ 3 billion and at 90 his net worth is over $ 90 billion. If generating CAGR over time is the gauge to assess performance of an investor then the most successful investor is not Warren Buffet, the most successful investor is Jim Simons. Jim Simons is the founder of Renaissance technologies, a quantitative hedge fund based out of New York, Simons compounded wealth at 66% annually since 1988. Simon’s net worth is $ 23 billion which is 75% less than Warrant Buffet’s. Simons started investing at the age of 50 and he had less than half as many years to compound as Buffet’s. Had Simons compounded wealth at 66% for 70 years as Buffet’s, his net worth would have been some astronomical figure. Buffet has witnessed several events like Gulf war, South East Asian economic crisis, Dot com bubble, Great financial crisis in 2008, pandemic etc in this 70 year of compounding wealth by 22%.
We always question our hypothesis for investments when we face crisis, a crisis of this magnitude where neither lives nor livelihoods have been spared, was never forecasted. Last year, we received calls from investors who were nervous with market volatility this year we have been receiving frantic and often morbid calls from investors who are anxious about their and their loved one’s Fear has the reputation of eclipsing rational thinking. This is the time where one should focus on maintaining social distancing protocol, on urgently vaccinating self and family and maintaining utmost vigilance on any symptoms of Covid and should not be thinking about one’s portfolios, if one has mapped one’s investment to one’s financial goals with their specific asset allocation mix. If invested haphazardly without a vision and a strategy then obviously uncertain times like this will compound miseries. Research conducted by Axis mutual fund in India reveals that investors have earned 15.6% CAGR vis-à-vis average diversified equity mutual fund’s performance of 22.1% CAGR from 2003 to 2015 which clearly reflects poorly on investor behaviour, lack of vision and strategy.
Financial planning, portfolio mapping with specific goals and patience are the quintessential attributes to experience success in achieving financial goals. Let us analyse some of the incredible and consistent compounders from the domestic mutual funds. Imagine investing INR 10000 per month for last twenty years in a diversified equity fund like ABSL Flexi cap fund earmarked for your retirement, you would have invested INR 24 lakhs which would be valued at INR 20,602,154 (INR 2.06 crores), your capital would have grown by 8.58 times and at a CAGR of 18.56%. The combination of compounding and rupee cost averaging had done this wonder. There are around 26 diversified equity mutual funds with twenty or more years of vantage and the average CAGR for 20 years of these funds through monthly Systematic investment plan has been a CAGR of 16.74%. Only a handful of investors have been investing in these funds for 20 years and have experienced the bliss of compounding and averaging. 20 years have been quite eventful, there were dot com bubble, Great financial crisis, taper tantrum, financial problems of some of the European nations popularly known as PIGS stands for Portugal, Italy, Ireland, Greece, Spain, Brexits and now we are facing probably the worst of the lot, this pandemic. None of these events have the gumption to disrupt the benefits that compounding and averaging offers but investor behaviour certainly has the potential to do so.