Patience is a virtue
We quoted earlier that numbers look good when tabulated. However, transforming them into reality could be a Herculean task. Well, not quite. An investment of Rs 10,000 per month for a period of 10 years has yielded an average of 12 per cent on a year-on-year basis even after a huge market fall as the adjacent table illustrates.
Most of the magic of compounding happens only at the end. It's time you planned on how to be a millionaire and maybe not theSlumdog way!
Discipline & diversification
To achieve the best risk-adjusted returns, it becomes absolutely necessary not to put all your money in the same basket. Having a judicious mix of debt and equity is equally important whilst you embark on your journey to become a millionaire.
Ravi had a moderate risk appetite and was keen on buying stocks especially at current levels given the fact that they are available at discounts to their actual value. He had limited knowledge about equities hence I suggested that he start off with equity mutual funds, which is also an ideal way to begin investing into equities.
Often, one is unsure of how much exposure one can assume: a thumb rule is to have equity exposure at 100 less your age; for Ravi it translates into 75 per cent (100 less his age, that is, 25 years) into equities and 25 per cent parked in debt (say fixed deposits for safety). Diversification is what will determine what returns you achieve. In table 1, we have illustrated three scenarios on returns: 8 per cent, 10 per cent and 15 per cent. Although risk is directly proportional to returns, one should aim to achieve optimal returns at risk-adjusted levels.
Start early, save consistently
Often, it is seen that investments are generally the last thing on your mind in your early 20s. You probably didn't know a thing about investing during your college days. The pocket money went straight to splurging on shopping, gadgets, theatres etc. The earlier you realise the importance of investing, the more time you would have for your money to compound and build a huge corpus. The adjacent table shows a simple representation of the power of compounding.
The table shows that if you save Rs 10,000 per month for 10 years (that is Rs 12 lakh at the end of 10 years) and if it compounds every year at a rate of 8 per cent then at the end of the 10th year you will get a corpus of Rs 18, 29, 460. But if you continue investing Rs 10,000 per month for another 10 years (that is Rs 24 lakh at the end of 20th year) and if this money compounds itself at 8 per cent then you build a corpus of more than Rs 58 lakh. That is you double your invested amount in 20 years.
Doesn't sound very mouth-watering, does it? No. Well, the power of compounding works handsomely when you let your money grow for a longer period of time as the table and the two illustrations below highlight. Apart from the time factor the other assumption that changes is the rate at which your money grows.
Now, if the same Rs 10,000 per month grows at 10 per cent per annum then your Rs 24 lakh (at the end of 20th year) will get you an amount that is more than three times (Rs 75 lakh) your invested amount (Rs 24 lakh). Likewise, if the same amount of Rs 10,000 per month (Rs 24 lakh in 20 years) compounds at 15 per cent every year for 20 years then you end up becoming a crorepati: that is, your actual investment of Rs 24 lakh returns Rs 1crore and 49 lakh.
Numbers do look good when tabulated; however, it is indeed a Herculean task to translate them into reality! You may observe now that it is not just time and money that commands the direction in which your corpus grows; there is one more important parameter which determines the same: rate of returns. For nobody can give you an assurance that your corpus will grow every year at a given rate.
What is compounding?
We aren't defining the mathematical term, the achievement of academics is to apply them in daily life.
The wonder of compounding (in investing terms) is to make your money work, to transform it into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on your asset's reinvested earnings. Compounding works on two basic premises: re-investment of earnings and time.
Simply put, the longer time you leave your money to compound, the higher is the wealth you generate.
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For withdrawals before the age of 60, 80 per cent of the accumulated money must be invested in an annuity and the remaining can be withdrawn as a lump sum.
For withdrawals after the age of 60, you have to put at least 40 per cent into an annuity. The balance you can take as a lump sum or in a phased manner. If you opt for the latter, you can phase it out till you are 70, with a minimum 10 per cent to be withdrawn every year.
The annuity will have to be taken from any life insurance company regulated by the Insurance Regulatory and Development Authority (IRDA).
If you die before you withdraw the entire amount, then your nominee can receive the entire amount in a lump sum.It's up to you to choose from the various segments.
E (equity): The equity investment is capped at 50 per cent of the investor's money and will only constitute index funds that replicate the Sensex or Nifty.
C (credit risk bearing instruments): Liquid funds, corporate debt, which are fixed return instruments issued by companies, fixed deposits and bonds (public sector, municipal, infrastructure).
G (government securities): State and central government securities.
If you cannot decide, the 'Auto Choice' comes into effect whereby the investment is determined by a predefined portfolio. Depending on your age, an allocation is made between the three classes of investment mentioned. For instance, up to 35 years of age, 20 per cent of the portfolio will be in G. But by the time you are 55, it will stand at 80 per cent.
