The Power of Compounding: How SIPs Can Help Build Wealth Over Time?

While I was growing up, I heard a story of a cruel King. He promised a poor Brahmin, who saved his life, to ask for anything in return. Brahmin took out a chessboard and placed a grain of rice on the first square. Then he asked the King to give him double the grain quantity (of the previous square) in the next square and so on till all the squares were filled. King laughed out loud at Brahmins' folly only to regret it later. 64th square required 9,223,372,036,854,780,000 grains. All the grains of his kingdom could not fill the last square alone!!

Of course, that's a story. I wish to share a fact before I jump to the actual point I am trying to drive. A baby starts off her human journey as a single cell in her mother's womb and multiplies rapidly. One becomes two, two becomes four, four becomes eight and so on. By the time she enters the real world, she has billions of cells in her body!!
We often hear about huge wealth creation in real estate over the years. Similar is the case of investments in equities, if investors had invested a long time back and continued to stay invested even today.

Unfortunately, most investors missed the bus and even if they did not, they terminated their investment midway on fears of correction or panic or some other cash requirement. This should be clearly avoided. However, we understand it's not easy to maintain that kind of discipline.

The good news is that there are products like Systematic Investment Plan (SIP) which make the whole process of investment easier and help maintain consistency. In SIPs, an investor has to invest a sum of money periodically. This period could be weekly, monthly, quarterly or even yearly. Investment happens usually in Mutual Funds or in select stocks or a combination of both. SIPs have been made for long-term investing to enjoy the benefits of compounding. Since investments are done regularly over a period of time costs are averaged out. The beauty of the product is that these can be started without any requirement of timing the markets.

If we keep historical returns in mind, Sensex has grown by 15.5% per annum over the last 45 years that we have. Conservatively, if we assume a 12% annualized return then an SIP of Rs 10000 per month can grow to approximately 1 crore in 20 years!!

There is a variant of SIP called Step Up SIP which is even more attractive. Here one has to invest a fixed sum every year but increase this amount by a fixed percentage next year. Each subsequent year requires a further increase in amount by the same percentage of the previous year.

If we take the previous example. A step-up SIP of Rs 10000 per month with an increment of 10% each year (over the previous year) and growing at 12% per annum can result in an amount of approximately Rs 6.5 Cr in 20 years!!

This is the power of compounding. Principles of compounding apply universally and investments are no exception. Unfortunately, the concept remains attractive in the thesis but is poor in investment application. In reality, greed & fear, mercilessly attack our minds and don't allow the magic to happen. Wise men, who have cracked the code, have created wealth others can only dream of.

Multibaggers are not created overnight. One needs to have a monk-like stoic devotion and conviction towards his stock pick. The clutter that comes along with the purchase needs to be shunned. The concept of SIP is based on sound fundamentals. It has to be backed by strong research and macro analysis. A bad stock selection for SIP can trigger havoc in reverse direction also. It can erode your wealth to an insignificant number if your selection is not good.

One caveat that is important to know. What has not happened in history can happen and thus become a part of history. Equity markets in India have never ever given negative returns in a block of 10 years or more. However, there is no guarantee of mathematics that we have presented above. Equity markets are inherently high-risk investments and the risks (including loss of capital) should be understood well before venturing into such investments.

The longer you stay, the more lucrative your rewards are. You must have heard several stories of children opening old, wretched wooden boxes of their father upon his demise, to discover some physical stocks valued currently at some mind-boggling number. While that changed their fortunes, it won't change yours. Most of us don't have that kind of fortune. We have to create our luck and for that, we need to change our mindset.

So, let's assume you have achieved nirvana by investing in magic products like SIPs and the magic potion of compounding has unfolded. What do you do? When do you enjoy the fruits of your penance? Well, the answer is simple---as and when you need it and as much as you need it.

In the good old days, it's said, people made a huge effort to search for the elusive philosopher's stone-chemical that converts metal into Gold. The truth is that this stone rests within us. The concept of SIP needs to be understood and reside permanently in our minds. If this is understood well, the treasure of wealth is not far away.

P.S- There are some basic thumb rules related to compounding, one can easily remember. Rule of 72 which gives time in years when 72 is divided by the rate of interest at which money is doubling. Similarly, the magical figures of 114 and 144 give the time frame in which money triples and quadruples respectively when divided by the interest rate.