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Applying the Power of Compounding to Asset Allocation
What happens when you combine the effects of two powerful concepts of investing? The results are enormously beneficial because they leverage the combined synergy. Power of Compounding can increase your returns significantly over the long-term and Asset Allocation can reduce the volatility in your investments. Combined together, this can help you meet both long-term and short-term financial goals.
Let us see how this works:
Harsh wants to invest 10,000 every month. He has two choices.
 Choice 1: He invests 30% (3,000) in a debt instrument, earning him 8% interest and 70% (7,000) in equity through a SIP in an equity mutual fund, earning 12% returns, compounded annually. Choice 2: He invests 60% (6,000) in debt, being a safer asset class and rest 40% (4,000) in an equity mutual fund.
Let us see which asset allocation mix gives Harsh a higher overall return at the end of 5 years.
In the first case, the amount that Harsh earns at the end of 5 years is 2,64,479 from debt investment and 7,40,183.5 from equity investments giving him 10,04,662.5 as the total amount.
In the second case, the amount comes to 5,28,958.1 from debt and 4,22,962 from equity assets, making Harsh earn 9,51,920.1 at the end of 5 years.
The power of compounding has worked more for equity as an asset class (as in the first case) and has earned Harsh 52,742.4 or 5.5% more than the second option.
The key to having the power of compounding work more, is to invest in asset classes that have the potential to generate higher returns. Hence getting the right asset allocation mix based on your risk tolerance and allowing compounding to work on it is important.
The power of compounding works better with high-yielding investments over the long-term. When planning your long-term strategy, choosing the appropriate asset allocation mix can optimise the power of compounding for you. This is the key to generating higher potential returns, helping you achieve your financial goal.
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#1
Understand how compounding works for each investment class, before deciding on an asset allocation mix that is right for you.
#2
Start early and keep your asset allocation higher on high-yielding investments for the magic of compounding to work over the long-term.
#3
Avoid going overboard with frequent rebalancing of asset allocation for compounding to work.