12 mistakes that interrupt compounding: what to do instead
This post is about how to avoid common mistakes that interrupt compounding.
12 mistakes that interrupt compounding: what to do instead
Posted on 10 Aug 2021
Author: Sayan Sircar
12 mins read
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This post is about how to avoid common mistakes that interrupt compounding.
📚 Topics covered:
- Introduction
- The compounding formula
- The factors we can control: how much we can invest
- The factors we can control: how long we stay invested
- The factor we cannot control: the return we get
- Never interrupt compounding unnecessarily
Introduction
Compounding is called the eighth wonder of the world for a good reason. ₹1 lakh invested at 10% over 30 years becomes (1+10%)^30 = ₹ 17.44 lakhs. More remarkably, in 5 more years, this becomes ₹ 28.10 lakhs.
To get from 1 lakh to 17 lakh, you needed 30 years. However, to reach from 17 to 28, you need just five years more. There have been cases of investments where people forgot about it for decades have checked and found lakhs/crores in the account. The majority of compounding happens in the later years when there is a significant corpus already accumulated.
We will now discuss common mistakes that investors make which prevent them from benefiting from compounding and explain what to do instead. Most of the examples related to market movement apply to stocks or equity mutual funds. The general principle of compounding applies to all asset classes.
The compounding formula
This formula is an example of an exponential curve where the current period growth happens on the entire corpus from the previous period. A good example is simple vs compound interest:
- simple interest: 100 > 110 > 120 > 130 > 140 etc
- compound interest: 100 > 110 > 121 > 133 > 146 etc
This interest-upon-interest feature is the reason compounding grows so fast as we see in the chart above. This feature is the premise of this quote:
My life has been a product of compound interest” - Warren Buffett.
The factors we can control: how much we can invest
This factor is 100% under our control. How much we invest monthly and what we withdraw has a substantial impact on the final corpus. Some examples of mistakes investors make:
Mistake 1: Delaying investments
We pay a heavy price by waiting to start investments since the amount of investment needed to reach the same goal rises faster than inflation.
Inflation: the impact on your goals and how to choose assets that beat it
Mistake 2: Investing too little
This issue happens when investors have not calculated the target corpus for their goals. Due to this issue, investors believe that a small SIP is sufficient for reaching their goals. They keep the rest of their investments in the bank, which does not beat inflation.
A SIP should also be increased every year as a step-up SIP as salary/income increases as part of the yearly goal review process. Assuming a 30 year investment period and average 11% returns,
- ₹ 1 lakh/year fixed SIP yearly leads to a ₹ 2.21 crore corpus
- ₹ 1 lakh/year SIP increasing at 10% yearly leads to a ₹ 6.04 crore corpus
- ₹ 1 lakh/year SIP increasing at 15% yearly leads to a ₹ 12.02 crore corpus
Investors can plan for their goals and figure out how much they need to invest using this Excel template. Investors can invest more and more amounts by increasing their income by enhancing their human capital. Read more on this concept here: Your human capital, not investment returns, is your biggest wealth creator.
Mistake 3: Withdrawing without a plan
So examples of this behaviour are:
- withdrawing money for short term goals like trips or car purchases just because some money has accumulated
- selling mutual funds believing market levels are high and not investing in alternative assets
- waiting for the best time to invest since markets are currently high
This particular mistake happens if investments are not tagged to a goal or lack a purpose: Why your Investment goals must be SMART?
What you can do instead:
- budget for trips using a sinking fund
- budget for car purchases and similar items using the single-goal template
- diversify your portfolio since in that case, all assets in the portfolio will not be high or low at the same time
- instead of timing the market, have a plan around exiting your investments as per your asset allocation
Mistake 4: Not being prepared for emergencies
Imagine that everything is going well. Suddenly you are hit with a medical emergency that leads to a ₹ 5 lakh out-of-pocket expense. There is no health insurance coverage.
Alternatively, the primary earning member dies without having term insurance. You get a ₹ 10 lakh coverage amount from an endowment plan. That money will get exhausted in 1-2 years.
All future goals go for a toss and require a fire-sale from the equity corpus to meet expenses.
Only sell equity assets from a position of strength. A defined asset allocation and rebalancing plan make that possible. Along with that, there needs to be a defensive barrier around your portfolio. Ensure that you have the following in place:
- An emergency fund with 6-12 months of expenses
- A term insurance policy (unless you are retired with no income)
- A health insurance policy (separate from the company-provided one, if any) for 10-15 lakhs as a base policy with a 50-100 lakhs super-top up
- A personal accident insurance coverage to safeguard against accidents where you do not die but cannot earn
- No high-interest debt like credit card or personal loans
Mistake 5: Ignoring taxes and transaction costs
If you invest in direct equity instead of mutual funds, then every sale transaction for rebalancing the portfolio leads to capital gains taxes.
Income-producing assets in the accumulation stage mean you are sacrificing return since that income is taxable at marginal rates. Examples are dividend-paying stocks/mutual funds or rental income. Instead, income-producing assets are better suited to the withdrawal or the retirement stage.
Trading frequently in stocks or mutual funds requires paying a sizeable amount in capital gains taxes that lower return.
Mistake 6: Failure to keep costs low
Investing in regular mutual funds or holding high TER mutual funds or other investments with high fees (like ULIPs) reduce the return. The alternative to high cost active mutual funds is low-cost index funds. See this article to know how to choose one.
Mistake 7: Paying too much interest
He who understands it, earns it; he who doesn’t, pays it - Albert Einstein
Paying the minimum amount on high interest-rate debt like credit cards while making discretionary expenses is an example of this situation. The family should treat debt as a personal finance emergency and make every effort to pay it off soon. The investor should cut down discretionary purchases like entertainment, trips and similar expenses while the debt exists.
The factors we can control: how long we stay invested
Mistake 8: Withdrawing abruptly
Investors tend to take some action if they look at their portfolio values too often. This habit leads to acting due to either greed or fear that hurts compounding:
- greed: letting momentum carry stocks higher and failing to book profits via rebalancing when the market corrects
- fear: exiting equity investments in a panic after the market has fallen instead of switching from debt to equity investments as per corridor-based rebalancing.
Investors should exit equity markets as per their glide-path, that is, when they want to as per their investment plan and preferably near a market top.
An excellent way to get that signal is when your rebalancing plan has defined corridors that get hit due to a market movement. For example, if the target allocation is 60:40 for equity and debt with a 5% corridor, then rebalance when equity hits either 65% or 55%.
Mistake 9: Constantly changing goals
All financial goals require discussion with the entire family to get their buy-in. Some items of discussion are large ticket items like
- do you need to pay for children’s education/marriage goals?
- Is retiring early a desirable goal?
- How much to spend on buying a house? If you pay too much as EMI, you will neglect other goals
- When to buy the next car and how much should it cost?
Without family members being on board with these goals will lead to:
- constant switching amongst asset classes as goal priorities change
- premature withdrawals from corpus kept for long term goals to fund other expenses
The factor we cannot control: the return we get
Unfortunately, most people are focused on improving the return from the portfolio at the cost of the first two factors. Market returns can be assumed but you will get what you Mr. Market gives you. This investor behaviour leads to
Mistake 10: Chasing returns
Investors investing in yesterday’s winning stocks, mutual funds or sectors often get sub-par returns. Investors should choose active funds based on the fund manager’s consistency in delivering index-beating returns. Alternatively, investors can eliminate human (both self and fund manager) risk by switching to index funds.
Mistake 11: Investing without conviction
Investors need to understand how to evaluate an asset for purchase or sale. Learning this requires skill and knowledge that takes a long time to master and there are no shortcuts.
However, it is easy to outsource investing conviction
- to experts in TV or newspapers talking about the best stocks/funds to invest in
- by subscribing to YouTube, WhatsApp or Telegram channels offering great returns sometimes for a small membership fee
- by asking for tips, best fund/stock names and portfolio review in social media
- following star fund managers or big investors in making trades without due diligence
Lack of conviction leads to
- exiting investments at the first sign of falling markets
- switching to the new “best” stock or fund
- investing in unsuitable investments by either taking too high or too low risks
- falling victim to various scams
- churning investments based on conflicting guidance
Mistake 12: Looking for exotic investments
Many investors believe that once their investible surplus increases, they need newer, more complex or exclusive investments. Some examples are:
- covered bonds that are new for retail investors in India without any information regarding how the issuers will handle a 2008-style default situation
- structured products that can be complex to understand and have high fees
- exclusive schemes that give fixed payments like 3%/month from equity markets which are likely to be a Ponzi scheme
- high yield company NCDs offering high returns (like 10%) with below investment grade (like AA) rating. These schemes attract investors looking for high returns with safety but may end up getting neither
Never interrupt compounding unnecessarily
Given that today index funds exist and goal-based calculators are easy to come by, it is easy to avoid these behavioural mistakes that impact compounding.
Step 1. Build defences around your portfolio
- Have an adequate emergency fund, term insurance and health insurance
- You must pay off all high-interest debt
Step 2. Know your goals
Follow this article series to set your goals: start here
Step 3. Create a plan that is easy to follow and can deal with market movements
This post deals with combining all goals into one easy to use Excel template.
Step 4. Keep costs low
The only certainties in investing are
- benefits of lower costs
- the mathematical impossibility of consistently beating the market index
This post shows how to choose investments suitable for goals at low cost.
Related Articles
- Your human capital, not investment returns, is your biggest wealth creator
- What are the axioms of personal finance?
- Why you should chase your target goal corpus instead of returns?
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