Imagine you’re growing a snowball by rolling it down a hill. As it rolls, it picks up more snow, making the snowball bigger and bigger. This is similar to how compounding works in investments.
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You start with an initial investment (the snowball’s core). -
You earn a return on that investment (the additional snow). -
The return is then added to your initial investment, becoming the new base for future returns (the snowball grows). -
In subsequent periods, you earn returns not just on your initial investment, but also on the accumulated returns from previous periods (the snowball keeps growing faster). -
The longer you stay invested and allow your returns to compound, the greater your overall growth will be.
The 7-3-2 Rule:
This rule is a simplified way to estimate the investment amount needed to reach a specific target corpus (total amount) considering compounding. It uses ratios:
7: This represents the portion of your target corpus that will come from your initial investment.
3: This represents the portion that will come from your returns.
2: This represents the ratio of your investment to the total amount (investment + returns) needed to achieve your target corpus in one year.
As per FundsIndia,it takes a painfully long seven years to reach your first Rs 50 lakh, but it takes only half the time that is 3 years to reach your second Rs 50 lakh and only two years to reach your third Rs 50 lakh. By the time you reach your 15th year, you add almost Rs 50 lakh every year!
The table below shows how the 7-3-2 rule plays out with different investment percentages at a 12% annual return.
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Compounding is the process in which interest is calculated on an initial principal sum of money and then further interest is earned on the accumulated interest as well. Compound interest can be thought of as “interest on the interest”, or in the case of investment funds, as “return on the returns”. Assume you are investing Rs 30,000 monthly at 12% annual returns.
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It takes a painstakingly long 12 years to reach the first crore. -
The 2nd crore takes another 5 long years. -
And then the power of compounding starts to kick in… -
The 3rd crore takes only 3 years! -
The 4th crore takes only 2 years and 3 months -
The 5th crore takes less than 2 years!
The second chart below also showcases the potential of SIPs with compounding. By investing Rs 50,000 monthly with a 10% annual increase in your contribution and assuming a 12% annual return, here’s what you could achieve:
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Year 1-7: Accumulate your first Rs 80 lakh. -
Year 7-10: Grow your corpus by another Rs 1.6 crore (including the first Rs 80 lakh). -
Year 13: Reach a significant milestone of Rs 3.2 crore. -
Year 17: Celebrate achieving your goal of Rs 5.6 crore!
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Three factors play a crucial role in reaching your crore-club dream:
Discipline is Key: Sticking to your SIP plan consistently, even during market ups and downs, is essential.
Incremental Growth Matters: Increasing your SIP contribution annually helps you reach your goal faster.
Compounding Does the Magic: Re-investing your returns lets your money grow exponentially over time.
Point to note: The 7-3-2 rule is a simplification and may not be perfectly accurate, especially for long-term investments.
The actual time it takes to reach your target corpus will depend on the investment return and the frequency of compounding (e.g., monthly vs. annually). This rule is a helpful starting point for understanding how much you might need to invest to reach your financial goals.
First Published: Jul 17 2024 | 10:37 AM IST
