Compounding rewards patience, but savings lay the foundation

Arguably the least celebrated and equally misunderstood part of personal finance is the power of compounding. The composition of wealth changes over time—from money you personally save to the money generated by what you have already saved—this phrase beautifully captures this essence.

I find that not many comprehend the often repeatedcliché to begin investing early because money compounds. Charts show small investments turning into astonishing sums decades later. The message is correct, but the way it is often understood is incomplete, as compounding doesn’t do much in the beginning.

Initially, in investing, wealth creation is overwhelmingly driven by one thing and only one thing: your ability and willingness to save. While the former is about the capacity the latter is about the intent. At this stage, the investment returns are small because there simply is not enough capital yet for the returns to be meaningful. Compounding is, in that sense, usually a tail-end consequence of disciplined saving.

The fascinating part of long-term wealth creation is therefore not just that wealth grows. It is that the composition of wealth changes over time. In the starting years, most of your corpus consists of money you personally contributed. Gradually, investment gains become meaningful. Eventually, the gains generated by your capital exceed the money you ever put into it.At that point, the relationship between you and your money changes.Until then, you are largely working for your money. After that, your money increasingly starts working for you.

Consider an Indian investor who begins investing Rs. 10,000 every month at age 21 and continues until age 65.Let us use a purely illustrative long-term return assumption of 8% per annum, with monthly investments. Actual returns will vary substantially and are not guaranteed.

The journey could look roughly like this: At age 25, a portfolio value of INR 5.6L has a contribution share of 85.2%, at Rs. 4.8L. In ten years, by the age of 35, the portfolio bulges to Rs. 30.8L where the compounding share increases to 45.5% from the earlier 14.8% with the gains contributing about Rs. 14L. And another couple of decades later at age 55, the total portfolio value is over Rs. 2.1Cr where the contribution is just Rs. 40.8L (19.9%) while the investment gains reach 80.6% of the corpus nearly of Rs. 1.7Cr. It only gets better at the next milestone of age 65, with the compounding share reaching 89.1% of the portfolio value of Rs. 4.89Cr over a cumulative investment of just Rs. 52.8L.

The numbers are illustrative but the pattern is unmistakable and important. The entire values, kind of flip with the initial compounding occupying under 15% to over 85% by the age 65. While compounding is present, it still is a supporting actor. That’s why it’s important to look at my initial statement where it’s not just the capability that matters but the intent too is as critical.

So, the first job of any young investor is not to compound or worry about returns but to build capital. This distinction matters with material consequences. A person in their twenties earning Rs. 50,000 or Rs. 1 lakh a month often spends considerable time worrying about whether their portfolio can generate 10%, 12% or 15%.But when the portfolio itself is small, the difference between these return numbers may matter far less than the amount being saved.

Suppose you have only Rs. 2 lakhs invested.Even a spectacular 20% return produces Rs. 40,000.But increasing your annual savings by Rs. 1 lakh immediately adds Rs. 1 lakh of fresh capital to your investment base.This is why the most important financial behaviour in the early years is often not chasing superior returns. But it should be about increasing savings rate, avoiding unnecessary lifestyle inflation, investing consistently and remaining invested.

In the beginning, the contribution is doing most of the grunt work, hence the younger years are precisely more important. It’s not because compounding does immediate wonders, but each rupee goes into the contribution forms the raw material for future compounding.

The crossover point is not when one reaches a target of Rs. 1cr or Rs. 5Cr but when your money catches up with you. It’s the moment when the gains generated by your investments exceed the money you personally contributed. It usually happens around the ages 35 and 45, if one were to begin their journey in mid-twenties.

At this point onwards, the question switches from how much to save to how to avoid interrupting the capital’s capability. People intuitively assume that if they invest for 40 years, wealth is created evenly over those 40 years. It’s not. Compounding is always backloaded. Probably the first decade often feels frustratingly slow where the contributions top the modest gains earned. This is the phase where the portfolio doesn’t yet look transformational because the returns earned in the beginning are primarily through your contributions.

There’s a tendency in personal finance to glorify investment returns and underappreciate savings. But compounding requires a starting base.

Advisors should spell the uncomfortable truth that one can’t compound on what that’s not first saved. This perspective is particularly important in retirement planning where the focus is always about projections of the final corpus and not invested capital.

Though, the formula for compounding explicitly derives power from the time, the magic often is an amalgamation of capital, time and uninterrupted participation. So, as you initially build the corpus, eventually the corpus builds itself.

(The author is a partner with “Welocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])

ABOUT THE AUTHOR

K Naresh Kumar

K Naresh Kumar[email protected]