The Secret to Wealth Creation

Wealth creation is more than just saving for your future. It’s also about ensuring your savings grow over time. While you can unearth the secret to wealth creation from books and articles, if you’re a lay investor, keeping two steps in mind can help in wealth creation in the long term:

• Using the power of interest compounding to your benefit
• Investing in the right asset classes for the long term

The Power of Compounding 

The power of compounding investment can be the core of your wealth creation strategy. Nothing illustrates the snowballing effect in investments like the power of interest compounding, to the extent that it has been called the world's eighth wonder!

Simply put, interest compounding means that you earn interest on the interest you’ve already made, which in turn multiplies your investments at an accelerated rate. Investing with compound interest can be a game-changer in wealth creation.  

Let’s assume you have invested in a stock at Rs 500 and earned a return of 10 percent on that stock over one year. By now, the value of your investments would have grown to Rs 550. 

Now, if you stayed invested, and in the second year as well, and if the stock again gave you a return of 10 percent, you will end up with a stock price of Rs 605. This is because it also includes the 10 percent or Rs 50 you earned in the first year. And that is how investing with compound interest can work wonders in your wealth-creation journey. 

Key Factors

Rate of return:

This is the profit you earn on your investments. Historically, equity-linked products like stocks or mutual funds come with a higher rate of return compared to debt investments or money sitting in a savings account. However, there is a caveat here. The higher the rate of return, the higher the risk in that investment. Therefore, it makes sense to actually ascertain the level of risk you are comfortable with first, and then choose the right asset class.

Time: The longer you stay invested, the greater the chances of compounding investment. Your money will obviously grow more over a 15-year period than over 10 years.

Taxation: The last factor, which is often ignored, is the effect that taxation can have on your investment wealth or returns. As you know, all your earnings are taxed. However, in the case of some investments, the incidence of taxes over the long term is lower as compared to an instrument in which you will be taxed annually.

Interest compounding will work if you start early, show discipline and are patient.

This is where a buy-and-hold strategy comes into play, as illustrated below:

Buy and Hold Strategy

Buy and hold strategy means buying a share or mutual fund and keeping it for a long time, regardless of the changes in the markets. While this strategy gives time to grow your investment, more importantly, it rides over any volatility your investments could face, especially in the short term. To put it simply, good things come to those who wait.

The advantages of this strategy are it helps reduce the cost of investing. If there is frequent churn or buy and sell in your portfolio, you can end up paying more as brokerage or other expenses. Risk can also be reduced as this can reduce repeated human intervention and judgement, which can lead to underperformance. This could lead to possibilities of better returns.

A passive investment strategy is ideal for long-term goals such as retirement.

Now, let’s combine the two

A combination of interest compounding and buy and hold strategy can work wonders for your wealth creation.

Suppose you started your investment journey with Rs 10,000. (The table above gives an indication of the effect of the rate of return and the investment period over wealth creation.)

If you had invested in an asset which gives a rate of return of 4 percent over 20 years, your investment wealth would have grown to about Rs 22,000. If you had invested in an asset class with the potential of generating a higher rate of return, which in this case let’s assume to be 12 percent, your investment wealth would be close to Rs 1 lakh during the same time.

Over a thirty-year period, that gap in the value of investments is what wealth creation is all about. While in the first instance, the earning would have been just over Rs 3 lakh, in the second instance, can yield a corpus of Rs 30 lakh.

Points to remember:

• The longer you stay invested, the more your investment can benefit from interest compounding.
• Keep in mind the tax implications of your investment.
• Be patient and disciplined.