Investment advisors never tire of telling us how it's always a good idea to start early and invest regularly so as not to miss out on the power of compounding. This is particularly true when it comes to selling retirement schemes and SIP investments.
While there is no dispute on starting early and investing regularly, we need to be wary of its use.
Advisors usually show workings on a spreadsheet of how money compounds over time in case of a bank deposit. But it may be misleading to stretch a deposit example to stocks and funds. Undoubtedly, equities and funds have delivered superior returns over the long run when compared to other asset classes, but this may not be only on account of compounding.
Two assumptions
The arithmetic of compounding works on two strong assumptions
(a) periodic cash flows at a contractual rate and
(b) the cash flows re-invested back at the same contractual rate and not consumed.
For a bank deposit that contracts to pay 8 per cent compounded over five years, compounding works because no interest is paid out, but is reinvested back and the same interest rate is applied on the enhanced corpus. In fact, in the case of fixed return investments, such as bonds, there is a third assumption, which is that there are no defaults in payments (credit risk).
But a mutual fund's returns are not by way of cash — they represent unrealised gains arising from the change in NAV over two time periods. For compounding to work, one would need to cash out gains every year and reinvest them back immediately, on the assumption that it is reinvested at the same rate. Clearly, this is not sustainable. It could be argued that mutual funds, by ploughing back their realised surpluses into the fund are working towards growing their NAVs.
Returns must be positive
But the fund returns are neither contractual nor guaranteed, let alone being re-invested at these rates. For compounding to work, fund returns not only need to be positive, but must also be consistent year-on-year. Even a year's negative returns can render the projections awry.
Among market instruments, theoretically, only a zero-coupon bond delivers a realised return that equals its priced yield to maturity. This is the same argument that is held against concepts such as the IRR (which relies on the principle of compounding) in interpreting financial projections. One needs to be cautious about relying on the numbers to plan one's future. The regulator's statutory warning about past returns being a proxy for the future should be borne in mind.
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