Every financial planner, IFA, RIA, RDA, CFP, CA, BE, MBA, MBBS, MD,  – all helping you in your financial planning MUST have told you “start early”. Have you wondered why?

Well there are many reasons, let me spell it out for you:

‘n’ is in the power position in the compounding formula – and has a very important role in compounding

the fun of compounding is ONLY when there is a decent size corpus to compound

compounding makes no sense for the first few years.

till you have a corpus, COMPOUNDING is just a fantasy

see your dad’s PPF passbook and see how from the 20th year onwards the total amount explodes. Interest on interest (Chakravarthy vyaaj – such a beautiful term) is awesome to see. Draw it on a graph – you will see a PARABOLA.

MOST IMPORTANTLY it helps you handle SEQUENCE OF RETURNS RISK

I do think that the first 3 points are easy to understand, and YOU know about it. Let us look at the sequence of returns risk.

From 1979 till date your money would have compounded at 19% and that is not bad at all. However if you were unlucky enough to start in 1987, 1993, or end of 2000 – you would have LOST more than HALF YOUR CAPITAL and in panic may have pulled out the other half! Losing half is TERRIBLE, but pulling out of the equity markets would have made it much much worse.

Sequence of Return Risk is the risk that you get very poor returns in the initial part of your investing life – and that leaves you with very little capital to compound. It also scars you badly, and your first reaction to a bull market is “let me pull out once I see my capital back to the sum invested”.

Let us take the case of a RETIREE who invested Rs. 10,00,000 in the year 1992. In 1993 it would have been reduced to 5,40,000. This may sound easy to you now, but for a RETIREE it is HALF his corpus gone. And you know how MSM would have made it worse. Much worse. So what would have been the man’s mindset? He would have pulled out in 1994 and said “I will not invest again in stocks”. Ditto for the investor of 2000. And both would have missed the GOLDEN period of Indian stocks.

How to handle the sequencing risk? Well:

  • if you are young and are doing a small SIP even if you get bad results in the earlier part of accumulating you can relax
  • you already have a salary, so the fall in corpus will HURT YOU LESS
  • as you have a long time to go, you will not worry too much about the corpus
  • as the market is doing badly you will accumulate MORE units
  • you may have parental support, medical insurance, etc. so less worries
  • you KNOW that bad years will be followed by good years AND YOU HAVE PATIENCE TO WAIT
  • you are more likely to leave your corpus in equities so will benefit from the boom (2003-7)

Look at the advantages – you are not being forced to sell (you are still living off your salary), you had lesser money to lose (after all ou started just now!!), …

I hope I am clear – an early start teaches you to be calmer. This is simply because you have time on your side.

 

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  1. Interest on interest… that too tax free… of course in the initial years one was sort of coerced to invest what seemed like a minimal sum and one didn’t simply have the money…

    So true this post, Subrabhai.

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