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Impact of 1% and magic of Compounding

Updated: May 7, 2021

Before I embarked on my personal financial planning journey, I never actually considered the impact that additional 1-2% returns could make on my portfolio. Most of my money was parked in fully taxable Fixed Deposits and Savings account and I was too lazy and careless to find out if I could further optimize the returns from these savings. Few of the reasons for not making any effort in this direction were:

  • Lack of adequate knowledge/ ignorance about Deposits with higher yields (with almost negligible level of risk) and various tax efficient bonds/ debt funds available in the market

  • Hassles involved in diversifying so much and then managing all the investments

  • I used to think even if I managed to get an additional 2% return with all this jugglery, it would not be worth the effort and the additional returns would hardly make any difference

  • I never really did any calculations to find out the long term impact

  • I thought I was already investing in equities and related funds (which I later realized was actually less than 10% of my overall portfolio) and hence need not make any changes to the money parked in debt and take unnecessary further risk

However, once I started working towards reconstructing my entire portfolio with detailed calculations, I realized how fallacious my above reasoning was.

Below is a snapshot of how a 10 Lakh investment grows with different rates of return and time periods.

As you may see, over a 10 year period, a Bank FD gives 20% higher return as compared to a savings bank account. However, investments in good high yield deposits have the potential to give almost 40% higher return over a regular savings account and the number is much higher for debt funds which provide long term indexation benefits. Returns from a good equity investments are in a different league altogether.

To understand the above returns through a better reference point, consider the below scenarios:

Over a 10 year time horizon:

  • Per day return on 10 Lakhs parked in Bank FDs (post tax @ 4.27%) = 142/-

  • Per day return on 10 Lakhs invested in good debt funds (post tax @ 6.8%) = 255/-

A substantial difference of more than Rs 110 on a daily basis on 10 Lakh worth of savings.

How many of us end up spending humongous time and effort searching for coupons/ discount vouchers just to get these tiny savings on a daily basis (at least I do)? You could have earned Rs 110 or almost Rs 3400 per month extra by moving into some good debt funds (on a 10 lakh investment).

Just to understand the power of compounding and the impact higher returns can have on our investments, let us take a look at another scenario. This is primarily for those who have parked all their money in Bank Fixed Deposits.

Over a 10 year time horizon:

  • Per day return on 10 Lakhs parked in Bank FDs (post tax @ 4.27%) = 142/-

  • Per day return on 10 Lakhs invested in good equity based investments (extremely conservative returns @11%) = 503/-

A huge difference of more than Rs 360 per day. Increase the time horizon to 15 years and the per day difference increases to a massive Rs 530 per day!! or more than Rs 16,000 per month on a 10 Lakhs investment. However, this is only true if you can continue holding your investments for as long as 15 years or more (we do that in PPF right?)

You can multiply the above numbers to the amount of corpus lying in your Fixed Deposit account (as a factor of 10 Lakh) and quickly find out the potential gains you can make by devoting little time and effort to your financial planning.

The above table also helps you understand how your investments could grow over long periods of time – thus showing the power of compounding. However, it requires extreme patience and discipline. Almost 75% gains are realized only during the last 25% time frame.

Just for reference purposes, below is a snapshot of the interest rate trends of SBI Fixed deposits over the years. You can view historical returns of some of the equity/ debt based mutual funds in this post.

Source: Interest rates taken from SBI Website

Note: Most of my articles are based on the premise of long term savings and investments (greater than 10-15 years). The idea of achieving financial independence is to take care of all your current expenses from your salary income only without touching your savings / investments thereby allowing your corpus to grow peacefully. This also drastically reduces the effect of any short term volatility on your corpus. The time horizon is based on the number of years one would need to achieve financial independence. This would depend on your expenses, savings rate and the minimum corpus which would be required to grow your wealth perpetually.

Please do let me know your thoughts. You can view all my other posts here.

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