Like all the good things in life, even wealth creation takes its own sweet time. The sooner you begin, a bigger corpus can be created. Unfortunately, most want to create it in a very short time or start too late. And that is the perfect recipe for disaster.
An early start, regular and disciplined investment pattern has an important role to play in wealth creation. And starting early is very important because gaining a head start also means that you'll retire with a larger corpus than someone who starts later in life. That's because the power of compounding works best over long tenures and therefore rewards the early bird.
Also, trying to play the catch up game in the later years puts too much stress on your finances. Let us take an example. If you start at 39, and put Rs 10,000 per month in an investment that yields 12 per cent a year, you will have Rs 1.12 crore by the age of 60 (over 21 years).
If you were to start a year later at 40, and invest the same Rs 10,000 per month at the same rate of return at 12 per cent, you will have Rs 98.9 lakh by the age of 60. Just a loss of a year has reduced your corpus by a whopping 13.8 lakh (over ten times the money you invested in a single year that is, Rs 10,000*12months = Rs 1.2 lakh). And if the rate of return were 15 per cent, then the difference would be as much as Rs 25 lakh. A clear example that time creates money.
And it is not just that. A late starter needs to invest more each month to create the same kind of corpus. For instance, if you are a modest income earner and start at age 25 with an investment of Rs 5,000 a month at 8 per cent compound interest you will accumulate Rs 1 crore by the age of 60 (considering that investment amounts and returns remain the same).
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But if you start investing ten years later at 35, you will need to invest 120 per cent more at Rs 11,000 per month for the next 25 years to reach the same target.
If we take the example of the public provident fund (PPF), if you save Rs 5,000 every month in it, you will amass over Rs 1 crore in 35 years (which currently returns 8 per cent compounded annually).
Of this, your savings component will just be Rs 21 lakh, the rest - nearly Rs 80 lakh, accrue to you as interest on your investments, which is reinvested in the same instrument, at the same interest. Clearly, the power of compounding at work.
No wonder, it is always advisable that you invest this PPF money at the very start of the month/year instead of waiting till year-end to take advantage of the Section 80C relief.
The difference of putting in Rs 70,000 (the maximum amount that can be invested for tax benefits) at the start of the year and at the end of the year will be around Rs 1.4 lakh over a 15-year period. Even depositing Rs 5,000 per month will result in much higher returns than depositing Rs 70,000 at the end of the year.
That brings us to compounding. If you park your money in an investment with a given return, and then immediately reinvest those earnings as you receive them, your investment will grow exponentially over time.
With simple interest, you earn interest only on the principal (that is, the amount you initially invested); with compounding, you earn interest on the principal and additionally earn interest on the interest. Compounding makes sure that your money works harder, and is perhaps the most powerful tool that an average investor can use to plan many of life's financial goals.
That is why financial advisors prefer that financial goals should be linked with investment plans that provide compounding returns. All fixed income life insurance plans such as endowment plans, money back, whole life plans and post office schemes operate on the principle of simple interest and not compounding.
However PPF and EPF in the debt space work on the principles of compounding and will definitely yield you much higher returns (for most tax slabs) than any other debt investment.