Learn the truth about compounding

We have discussed the need for financial planning in previous articles. Now, let’s talk about a few guru mantras which will help in attaining financial independence. The first mantra is to start early. Like the story of an ant and a grasshopper, start saving for the rainy day as early as possible. The power of compounding makes a huge difference on early savings. Each day’s delay causes loss of compounding and, hence, one should start as soon as one can.

Let’s make this example clearer with the help of the 1969 film ‘Sachaai’, starring Shammi Kapoor and Sanjiv Kumar. Ashok and Kishore are two friends who have studied together for long and graduate at the same time. Both of them land good jobs with different companies in different cities, at a starting salary of Rs 50,000 per month. Ashok is a happy-go-lucky person and believes in enjoying his life. The monthly salary he receives is spent on cultivating a good lifestyle. Ashok spends on branded clothes, eating out, travel and expensive gizmos. Kishore, on the other hand, is a conservative person. Having come up the hard way in life, he is a reluctant spender. He believes in not spending beyond his means. Kishore saves Rs 15,000 every month. Obviously, he sacrifices a lot of pleasures in life. He rides a bus while Ashok prefers a personal cab. He eats at Udipi hotel while Ashok indulges in fine dining. He buys at clearance sales while Ashok goes for branded stuff.

This continues for 10 years. Ashok and Kishore meet at the college reunion. Ashok is nicely dressed and is the centre of attention as he talks about the good things in life. Kishore is ignored by most as the subject of his talk is dry and boring.

However, Ashok and Kishore discuss with each other everything about lifestyle and saving. Ashok has no cash balance. Kishore talks about saving Rs 15,000 a month. Kishore talks about his simple life and Ashok talks about his colourful lifestyle. Both of them realise they have been missing each other’s style in their life.

After that night, Ashok becomes a saver and saves Rs 15,000 a month for the next 25 years. Kishore becomes carefree and does not save anything but doesn’t touch his accumulated saving. After a period of 25 years, Ashok and Kishore again meet at the college reunion. By then, Ashok has saved Rs 15,000 every month for 25 years (albeit 10 years after Kishore started saving), resulting in a principal saving of Rs 45,00,000. Kishore has saved 15,000 per month for just 10 years (albeit ahead of Ashok), resulting in a principal saving of Rs 18,00,000. Ashok has saved 2.5 times more in amount and time than Kishore. However, to the utter surprise of Ashok and Kishore, Ashok’s bank balance is Rs 2.84 crore whereas Kishore’s is Rs 6.90 crore (assuming 12 per cent monthly compounding with no tax payable). Ashok has saved 2.5 times more in terms of time as well as amount, but Kishore’s bank balance is more than 2.42 times Ashok’s. This surprise is known as compounding. As Albert Einstein mentioned, it does not stop. The earlier you save like Kishore, the better your prospects.

Compounding is the best friend of an investor. Use it to your advantage to the hilt. Don’t wait for an opportune time to save money. Start saving from whatever you have, whenever you have. Early saving is like planting seeds in fertile land. Give it some time and soon it will start growing from a small seed to a small plant to eventually a big tree. The ‘Sachaai’ of financial independence starts with early saving. Hope after reading this article, your will walk instead of taking a cab and put that saving to work for compounding.

(The author is president, corporate banking, Axis Bank)