Saving Early. The Magic of Compounding.

Recently, I came across an article on saving early that claimed something which seems extraordinary on the face of it. It claimed that if you started saving for your child’s(!!) retirement at the time the child is born, then something extraordinary happens.

If you save 5000 Rs. a month, the article claimed, and you put the money into equities( where return was supposed to be 18% per annum, as per the article), and if you kept increasing this sum by 5% per annum (so that in year 1, you were saving 5250 per month, and in year 2, a little more than 5500 per month), and you kept saving for the first 20 years of your child’s life, and then stopped, keeping the corpus intact, then, the article claimed that at the time of your child’s retirement (Age 65), your child would have 1000 crores of Rupees.

Extraordinary, isn’t it? The magic of compounding plays out so wonderfully, when you start compounding over 65 years. I tried to do the calculation myself, and I in fact, assumed that the entire money (60000 Rs.) would be invested in the beginning of the year itself. And that led to the even more astonishing figure of Rs. 2700 crores.

Of course, this isn’t particularly realistic. The first assumption is that you would get 18% return on equities. Frankly, this isn’t a very tenable number, and very few individuals would have obtained 18% a year over 65 years (Warren Buffett is one of them, but then, he is both an owner and an investor, and he has float from insurance companies). A more realistic assumption would be something like 13-14%.

However, even if you assume a smaller return of 13%, the figure still comes to a respectable 212 crores. If you assume an inflation rate of 5%, then that comes to nearly 10 crores in today’s money, surely a comfortable sum to retire on for most people. Maybe 9 crores after taxes.

It also goes to show, the importance of saving early. It is the 65 years of compounding which causes these crazy sounding figures to come up.

Most people, of course, struggle to save for their own retirement, let alone their children. So let us look at how saving early can help such folks.

Suppose a person starts working at Age 22, and works till the retirement age of 65. Suppose they save 60000 per annum at the end of every year (or 5000 a month). And they invest it only in PPF account, which gives them 8.5% tax-free (Not counting the impact of the tax benefit of such an investment at the time of investment).

In that scenario, they would have a corpus of 2.45 crores at the age of 65.

Suppose, you start saving at the age of 30, i.e., 8 years later. In 8 years, you would have saved only Rs. 4.8 lakhs less than the individual who starts saving at the age of 22. But in this case, at age 65, you would have only Rs. 1.26 crores at the age of 65. A huge Rs. 1.2 crores less.

Maybe we take a more realistic scenario, where the amount you can save increases with time. Suppose you start saving Rs. 5000 a month at age 22, and increase this by 1/3rd every five years, then at age 65, your corpus will become Rs.4.9 crores. And if you do the same thing, starting at age 30, you would have only Rs. 2.2 crores. The difference gets even more magnified.

And this is assuming only a 8.5% return. Recently, I checked my NPS returns (I have been saving in NPS since 2010, in a 50:30:20 portfolio (50% equity, 30% Government Securities, 20% corporate bonds), which is relatively conservative. In this scenario, my return has been a little under 10.5% over these 9 years.

If we would plug in these figures, the small tweak in the return, leads to a scenario where instead of Rs. 4.9 crores in the scenario earlier, then corpus would become Rs. 8 crores (Saving Rs. 60000 every year from age 22, increasing by 1/3 every 5 years). As opposed to this, starting at age 30, the corpus would have become only Rs. 3 crores, as opposed to Rs. 2.2 crores. The higher return has dramatically magnified the advantage of saving early.

This last comparison is illustrated in the graph below.

The Importance of Saving Early is well demonstrated in this graph
Shows the cumulative corpus if Rs. 60000 is saved every year, with the sum increasing by 1/3rd every 5 years, and a return of 10.5% per annum..

The first lesson in personal finance is therefore, to start saving early. The second is to try and maximise the return. In another post, I will try and explain why, if your horizon is long, it is sensible to be a little more aggressive and bump up your returns.

Portfolio Composition on February 17, 2017

While much of the discussion here is on financial markets, my personal investments are more diversified. More than 50% of my investments are in real estate (including my self occupied house and office*). My equity investments (including PMS, Equity Mutual Funds and Direct Equity) amount to less than 25% of my total investment. Trading Equity(**) amounts to less than 7% of my entire set of investments.

Over time, I expect to see movement in this portfolio composition, with the relative allocation to equity increasing, the allocation to  indian real estate investments decreasing, the role of overseas real estate investment increasing (from zero presently), the allocation to  angel investments increasing and the role of bullion rising to around 2% of porfolio.


P.S. * I debated whether to include my self occupied house and office in my total investments. The reason for the debate is that you are unlikely to sell your house or office, so why include them in the mix. I eventually included them, because both are really too large for my long term needs. They are fungible, because I could also move to smaller spaces at a much lower cost.

P.P.S. ** While the amount of trading equity is only 6.7%, in reality, it is larger, if I include the cash I hold in reserve for drawdowns, and the stocks that I can give as margin for trading.

Links to Great Articles on Creating Wealth

Articles on wealth creation

Here is a nice post on the habits of people who have created wealth, and the rules you can follow to get there.

What is the difference between Getting Rich and Staying Rich.  The link has a great article on staying humble to stay Rich. I would also add that remaining teachable is also a good way to staying rich. It is hubris that can make the difference between Getting Rich and Staying Rich.

The wealth creation journey is not a slow and steady one. If one wishes high returns, one must be prepared for high drawdowns as well. The drawdowns are both in terms of money and in terms of emotions. Here is a great article which talks about the importance of stoicism in the wake of large drawdowns, and why reacting with equanimity to a large drawdown is critical if one wants monster returns.

Here is another one along the same lines where the author talks about how short-term loss is the price of admission into long term gains.