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Start saving early and wait patiently for compounding of returns to take effect, argued the author of an audio book that I was listening to recently. This may not work well for goal-based investments. Here, we discuss two reasons why this may be the case — time-bound objectives and asymmetric returns.
Compounding pain?
You save and invest to accumulate wealth to achieve a goal. Now, goals have finite time horizon. It is true you should start early to achieve a goal. That way, compounding can work. But, it is highly unlikely you will know well in advance what goals you want to pursue, except for two primary goals — funding child’s college education and, perhaps, retirement. Starting early is, hence, difficult for goal-based investments.
Suppose at 28 you decide you want to buy a house five years hence. You could start saving from next month, but have only five years to accumulate enough wealth to make the down payment. So, the argument you should wait patiently for compounding to take effect does not hold water for a time-bound objective.
There is another issue. Compounding of return helps for bond investments (read bank deposits), as interest rates are typically positive. Consider the rule of 72. If your bank deposit pays 6% a year, it will take about 12 years for money to double (divide 72 by 6). But negative compounding hurts badly. Why? Suppose you must earn 12% each year on equity investments to achieve the goal. A negative return experience means you must recover not only the unrealised losses but also earn 12% return required to achieve the goal. Imagine the impact on your investments if you face consecutive years of negative returns. Compounding of returns may not be always helpful for investments earning capital appreciation.
Conclusion
The above arguments do not mean you can’t benefit from compounding of returns. There are two specific cases when compounding reduces investment anxiety.
Suppose you have accumulated only 65% of the required wealth in your retirement portfolio at 50. Based on the rule of 72 (using post-tax returns), you can still hope to achieve the goal in the last ten years of your working life, assuming you retire at 60. The other instance is when you are saving to accumulate wealth with no time-bound objective.
(The author offers training programmes for individuals to manage their personal investments)
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