The compounding effect is not linear!

The Nifty 50 Total Returns Index (TRI) delivered a 10.36% CAGR between Mar-08 and Mar-23. ₹1 lakh invested in Mar-08 would have become ₹4.4 lakh in the 15 years through Mar-23.

Does that mean, at a 10.36% compounded rate, your investment in Nifty 50 would have grown steadily year after year? Meaning, would your INR 1 lakh invested in March 2008 have become ₹1.64 lahks in March 2013 and ₹2.68 lahks in March 2018?

Not really!

In March 2013, your investment would be worth only ₹1.27 lakh. In March 2018, it would be ₹2.40 lakh.

Why this difference? Look at the chart below. The red line is how 10.36% would grow steadily. The blue line is the actual monthly movements of the Nifty 50 TRI over 15 years.

The curve is full of ups and downs. Most movements are below the linear compounding line. So, the returns would have been less than the 10.36% average in most periods. Only a few large positive swings have resulted in the 10.36% CAGR.

Why does this happen? Markets are volatile, and that’s the very nature of the markets. Several economic, social, political, natural, and uncertain events influence the market daily. One cannot know the frequency and magnitude of such events. Investors and traders keep adjusting their expectations in response to every event. The result is volatility.

What is the way out?

• Stay invested. Volatility smoothens out over more extended periods and delivers good returns. Irrespective of daily or monthly ups and downs, the curve, or the red line in the chart, is upward-sloping. Your investments are more likely to grow if you remain invested.
• Zoom out: Avoid checking your investments daily. So many poor return periods over the last 15 years could have triggered you to exit your investments. But if you had remained invested, the returns would have been decent.
• SIPs: Invest a fixed amount every month or quarter. Systematic investment plans are your best bet against volatility. When the market is down, your regular SIPs can buy more units. When the market is up, those units will show strong returns.
  Investing a large sum all at once might suffer with start-point bias. If the market price falls immediately after your lump sum investment, it might take to be net positive. SIPs help average out near-term volatility effects.
• Diversify: All your investments do not have to be volatile. Have some FDs or safe government debt to see lesser volatility at the portfolio level. For goals that are five or more years in the future, you may choose equity. For nearer-term goals, prefer FDs or debt.

Did you know that full redemption at once can carry end-point bias?

Market directions are difficult to predict. If the market rallies right after your redemption, you might regret acting early. If the market tanks right after your redemption, you might thank god for acting early.

People who need money over a period of time, and not all at once, can use Systematic Withdrawal Plans (SWPs). It can iron out your average redemption rate. And the amount that you do not withdraw gets more time to compound.

What if volatility unsettles you? It is totally natural if you do not like to see your investments go negative. You could invest in a fixed deposit. Fixed deposits can give you 6-8% returns depending on the interest rate environment and which bank or NBFC you are keeping a fixed deposit in. FDs compound at a lower rate but do not exhibit volatility.

The difference between the red and blue lines represents the difference in returns between 7% and 10.36%. But we also know that 10.36% comes with a lot of volatility.

FDs will not deliver equity-like returns but will give you peace of mind if you do not want volatility. It is a trade-off you make:

• Accept some volatility with the hope of making slightly higher returns
• Eliminate volatility but make fixed, slightly lower returns.

When diversifying your portfolio, your allocation to equity and fixed income also depends upon your preference and comfort with volatility.

The Personal Finance Module on Varsity discusses the Compounding Effect in detail.