One Simple And Effective Method To Create Wealth

Monday, January 28, 2013
By Kripananda Chidambaram

Kripananda Chidambaram is Director of Fintotal Insights and Resources

Investing
With Rs 15,000 per month to spare, is there any way I can make Rs 50 lacs at the end after 10 years?

Can a mid level salaried employee ever afford a BMW?

How much money should one need to earn to get wealthy?

These are the type of queries I frequently keep getting at my workshops.  Majority of us strive to get rich and wealthy. Money makes us go around and we take lots of stress and pressure to earn money. Wealth creation is one of our major goals of life. We spend a substantial part of the day, every day in earning money.  

We keep doing many things to achieve wealth, few of us keep switching jobs for higher pays, take part-time jobs for additional income, trade in stocks, do some savings here and there etc.

This week let us pick up one method that shall help us create wealth:  COMPOUNDING. A rather simple one too!

The one proven and easily implementable method of wealth creation is compounding. Compounding is very powerful tool and unfortunately many of us underestimate its utility. Compounding happens when you invest your money and the return it earns is reinvested back. That literally means you invest and do not take any returns till the end.

Compounding sounds like a mathematical word; but at the root, it is just the way we observe many natural phenomena. Whether it population of the country or rise in prices, change happens as a fraction of the current value. If India’s population is growing at 2%, the absolute numbers are growing faster and faster, since the base is increasing. This is the crux of compounding.

In the world of finance, to make understanding uniform, we take compounding on an annual basis. If numbers are expressed with any other time frame, we simply convert that into an ‘equivalent’ annual number.

Not taking returns out periodically can make a huge difference! Albert Einstein called this as the 8th wonder of the world.

The formula of compounding is investment*(1+interest rate)^no of years

What products allow you compounding?

Practically all asset classes can be put into compounding. In the income assets category you may look at fixed deposit with cumulative option, long term discount bonds, investment cum insurance policies, debt mutual funds with growth or dividend re-investment option, etc.  In growth assets the compounding automatically happens in case of real estate, stocks, gold, growth option in equity mutual funds etc.

So all you need to do for wealth creation is let your money compound. Compounding is truly putting your money to work. Compounding is money working for your, money multiplying itself.

Now, you may still have one more question in your mind. Where to invest?

Compounding itself is a powerful thing irrespective of the product you invest in. But one thing you always want to do is preserve the values of money i.e maintain the purchasing power.

For that to happen you may have to choose products that can beat inflation. Inflation literally is the compounding of prices. Assume a product is priced at Rs 100 today and the rate of inflation (increase in price) is 9% per annum. Apply the compounding formula and you will find that after 5 years you need to pay Rs 154 to buy the same product. This is what you need to be careful while choosing an investment product. Your money should grow at a rate more than the rate the product price increases.

Which are those products that can grow at a more than inflation?

The answer is growth assets. Examples of growth assets are real-estate, gold, equities, equity mutual funds, etc.

In fact most of us perceive real estate or gold to be big wealth creators as compounding is inherent in them. But to play the real-estate game you already need to have a decent corpus, which might not be the case with many salaried employees.

Then what are the options left with them? Gold, equities or equity mutual funds.

Gold is one good option but do not go overboard with it.  Gold is an unproductive asset and a bit anti-India as well. More essays on them later but for now restrict you maximum savings to less than 15% of your investment corpus.

Then the options left are equities and equity mutual funds. Beginner’s can skip direct equities as it is fairly complex and time consuming.

Now the only choice left with you is equity mutual funds. No it’s risky! is the response many will have. Yes it is risky only if you look at it in short term perspective. In the long run, in all likely hoods you will never lose your capital.

So for a salaried employee who has surplus on a monthly basis, mutual fund is the best option. Investing on a regular (monthly) basis in a mutual fund is called as SIP.  SIP in a large cap diversified fund will do the job for you. Though referring to past does not make sense but just for the sake of illustration let us see the below case:

If one had invested Rs 15,000 say in HDFC Top 200-G from Jan 2003 to Dec 2012 he would have had Rs 55 lacs today .i.e. 21.4% p.a.

It is obvious that past results may not be repeated, but if the economy grows at 8-9% in the next decade or so you may see similar returns in future as well.
Just to summarize the method of wealth creation; Allow your money to compound for long term by way of SIP in a large cap equity diversified fund (Index fund).

Compounding is very powerful tool and unfortunately many of us underestimate its utility. Compounding happens when you invest your money and the return it earns is reinvested back. That literally means you invest and do not take any returns till the end.

Compounding sounds like a mathematical word; but at the root, it is just the way we observe many natural phenomena. Whether it population of the country or rise in prices, change happens as a fraction of the current value. If India’s population is growing at 2%, the absolute numbers are growing faster and faster, since the base is increasing. This is the crux of compounding.

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