If you're wondering what is compounding or does compounding even work in mutual funds, watch the latest Investors' Hangout with Dhirendra Kumar
19-May-2023
What is compounding?
Compounding - we keep hearing about it all the time, and it's very simple - money makes money and the money that has been made also starts making money the moment you have it. So, it keeps getting added and that is how it combines and it actually accumulates into something very substantial. So, this is why Einstein actually referred to compounding as the eighth wonder of the world.
How does compounding work?
Let me explain how it works with an example. If you have a lakh of rupees, you make a bank deposit and you earn 10 per cent in the first year. The money becomes Rs 1,10,000 in the second year and you earn interest on Rs 1,10,000. After you have made that Rs 11,000 In the second year, that will be added back to the capital and it becomes Rs 1,21,000 and now you will earn 10 per cent on this. So, this is how compounding works, and it clearly gets demonstrated in fixed income.
But many times compounding is not as straightforward - for uneven cash flow, for something which grows generally but not at a specific rate and not generally every year. So, if it is less periodic, if it is uneven, if it is a little erratic, sometimes it does not happen, then many times people are unable to relate how it is compounding. But the very underlying nature of compounding is that money makes money and then the money that has been made also starts making money.
How does compounding work in stocks?
Yes, that is the nature of the equity because you start a business, you earn and you share a part of the profits by way of dividend and rest of the money, most businesses reinvest in themselves. And most businesses grow over a period of time.
Let me just explain to you with one example. We have all heard of Maruti Udyog and I just picked up some numbers to share with you. In 1997-98 Maruti Udyog sold 3.5 lakh cars. And in 2021, it sold 16.5 lakh cars. So, this is the growth that you see. How much was the worth of those cars then? It was Rs 8,478 crore, today it is worth Rs 83,800 crore. So, you see the 10 times growth during this period and its profit grew from Rs 651 crore to Rs 3,776 crore. So, this is compounding because company kept making money, kept making cars, different kinds of cars, improved cars, people liked them and it kept growing its business, made profit reinvested and made more, set up more plants, more brands, greater distribution, and then it became a bigger company, and this is compounding This is a compounding which we have seen in the last 25-30 years. The company started in 1985 from ground zero and today it has become the largest passenger car manufacturer in India. So, this is compounding and that is the nature of any business which is into producing or delivering goods and services to grow and make profit and reinvestment of those profits.
But the growth of Maruti Udyog to Maruti Suzuki may not have happened in a very nice linear fashion like Public Provident Fund interest income where you earn 7.5-8 per cent and year after year and the capital gets added. Let me just explain to you the erratic nature of equity compared to guaranteed returns, something like Public Provident Fund. If anybody would have started with Rs 10,000 annual investment in PPF and carried on so far all these years, he would have invested Rs 4.5 lakh for 45 years. This would have grown to something like nearly Rs 73 lakh which translates into about 10 per cent annualised return because the earlier years PPF return used to be higher. And assuming the money remains invested you will have Rs 73 lakh. If you would have done the same thing in Sensex which has existed since 1979 and the base was 100, you would have invested the same Rs 10,000 every year aggregating Rs 4.5 lakh, it will be worth Rs 3.11 crore which translates into annualised return - compounded annual growth rate of 14.56 per cent.
So, this is significant and why does it happen in equity? Simply because they reflect the real economy and it would have come with all kinds of risks. Sensex has witnessed corporate mortality, many companies died in these 40 years Hindustan Motors was a Sensex constituent, many companies which existed as part of Sensex don't exist anymore, they died on the way. Despite that, despite those companies dying, despite those companies tanking, some of the companies going bankrupt, some of the companies doing so poorly even though they exist but they have actually lost investors' money, the diversification worked. In case of Sensex, we have these sizable companies getting out of Sensex, or dying after getting ejected. Despite that it translates into 14 and a half per cent annualised return. So, this is the magic of equity coupled with magic of compounding.
Does compounding benefit get transferred to mutual funds?
In case of fixed income funds, it compounds somewhat like a deposit but without the guarantee. But in case of equity funds, you have this underlying nature of the underlying asset which is reflected here. Like in the example which I was giving earlier about Sensex. So, you can consider Sensex as a mutual fund which is diversified, which is facing all kinds of mortality, all kinds of risks, all kinds of ups and downs and many times it would have gone down in value by 25-30 per cent in a quarter or in a year. Despite all the ups and downs, it gives such a superior return because the underlying is the same.
The nature of a company to grow or a well managed company earning more than inflation, being able to adjust the goods and services w.r.t. inflation gives the pricing power. So, all these things get reflected in the nature of equity returns and so, it will not be precise, it will not be like 7.5 per cent every year compounded quarterly. But the nature of equity is that it grows over time and if you remain invested, it compounds.
How to maximise the benefit of compounding?
The simplest way to maximise the benefit of compounding is to have a long-term timeframe. Let the magic work because money makes money or the company grows, and let it grow further.
Then comes making sure that you are adequately diversified. Because if you try and do this magic with a very narrow universe, you will be exposed to greater risk. So be very diversified. And don't get scared, have the belief because many times the biggest disruption to compounding is when you are scared out of the market and when you pull out of equity. So when you are faced with that grim situation, there will never be a brighter day - the market has tanked and everybody's scared and we think that we have lost money, which you will never recover - I think gaining that perspective that it's a fairly routine thing in the market and rewards come your way only if you're able to withstand that.
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