Impact of 1% and magic of compounding

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 mutual funds (which I later realized was actually less than 10-15% 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. More than 80% of my investments were giving me less than 6-6.5% post tax returns (PF was the saving grace here). 

Below is a snapshot of how a 10 Lakh investment grows with different rates of return and time periods (Tax considered at 30%).

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 investment are in a different league altogether. 

To get a better context/ reference point, consider the below scenarios:

Over a 10 year time horizon:

• Normal FD: Per day return on 10 Lakhs parked in Bank FDs (post tax @ 4.27%) = 142/-
• Good debt funds: Per day return on 10 Lakhs invested in good debt funds (post tax @ 6.8%*) = 255/-

*Debt funds provide indexation benefit. Return values are approximate based on past data.

A substantial difference of more than INR 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)? I could have earned 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 FDs and not willing to move to better investments for various reasons.

Over a 10 year time horizon (tax considered at 30%):

• Normal FD: Per day return on 10 Lakhs parked in Bank FDs (post tax @ 4.27%) = 142/-
• Equity Investments: 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.

Below is a snapshot of the interest rate trends of SBI Fixed deposits over the years and how it has been going down. The net tax returns are hardly able to beat inflation.

Data Source: SBI Website

On the other hand, below are the returns from some of the largest Large-Cap & Multi-cap funds:

As you may observe, there is quite a significant variation in the returns of mutual funds. Given the huge difference a 2% return can make to your portfolio, it is essential that one spends significant time and effort in searching for the best mutual funds as well. 

To summarize:

• Strive for the best returns possible
• Even a small difference in return rates can make a huge difference in the long term
• Invest for a longer time horizon to get the benefit of compounding and do not worry about short term fluctuations
• Investing even a small sum regularly will ultimately compound to generate huge returns

Note: This article was originally posted here.

(Disclaimer: Accuracy of data is not guaranteed. I have taken data from multiple external data sources. I am not recommending or advising in favor of/ against any particular fund/ stock mentioned above. These are my personal views only. I may/ may not have positions in the above mentioned funds/ equities.).