The power of compounding

A guide for beginners to initiate investments through Systematic Investment Plans

KARACHI:

Pakistan is a country with a young population as almost two-thirds of the population is under the age of 30. This young population has the potential to become a driving force in the country’s economic growth.

For young adults, starting early with investments such as SIP (Systematic Investment Plan) can be a wise decision. The earlier you start investing, the more time you have for your investments to grow and compound.

Starting early with small investments can help young investors build a diversified portfolio over time. The power of compounding can make a significant difference over the long term, and starting early gives investors a head start.

With the right approach and investment strategy, young investors can create a solid foundation for their financial future.

During times of high inflation, the cost of goods and services tends to rise, which reduces the purchasing power of money. This means that your money can buy less today than it could in the past.

Inflation can erode the value of your savings and impact your ability to meet future financial goals.

A majority of the investment cannot match the existing short-term inflation in Pakistan, however, by starting early and consistently investing, individuals can build a portfolio that can provide a cushion against inflation and help achieve their long-term financial goals.

SIP is a disciplined investment approach where an investor invests a fixed amount of money at regular intervals, typically monthly. To invest wisely, after setting financial goals, investors should determine their risk tolerance.

Know your risk-return profile

Different investment schemes carry varying risk levels, so it is essential to understand your risk appetite. Choosing a scheme that exceeds your tolerance may lead to portfolio losses.

For risk-averse investors, fixed interest rate schemes are an option, but they may not help reach goals in an extreme inflationary environment. A combination of fixed-income and equity-linked schemes are a better choice for those seeking capital appreciation and an aggressive approach to their portfolio.

However, if you have decided to invest in stock market, keep a long-term investment horizon: in hyperinflation, the stock market can be extremely volatile, and short-term market movements may not reflect the long-term potential of an investment.

Therefore, it is important to keep a long-term investment horizon when investing with an aggressive approach through SIP.

Patience pays off in long-term investing, so it is important to exercise patience when investing for the long term, rather than seeking quick returns.

Moreover, invest in mutual funds that offer multiple asset classes such as equity, debt, hybrid, ETFs and gold because it can provide diversification and help manage risk.

Here are some tips on how to use SIP in the current hyperinflation scenario:

Investing in inflation-resistant assets

In hyperinflation, the value of the currency decreases rapidly, which means that the value of investments in traditional assets such as stocks and bonds can also decrease rapidly.

It may be beneficial to invest in liquid and short-duration money market or in assets that are resistant to inflation, such as gold and real estate investment trusts (REITs).

In current scenario, Shariah-compliant money market funds are offering attractive returns of 16.75-17.25% while Shariah-compliant fixed term plans are offering a return 100 to 200 basis points (18.5-19%) above these money market mutual funds.

Power of compounding

Compound profit has a remarkable ability to increase wealth, especially when compounded frequently. To help readers understand the power of compounding in SIPs, let’s take a look at a hypothetical example.

Assuming the use of monthly cash funds for investment purposes, retirement age of 60 years and a historical 32-year weighted average policy rate of 11.5% (using a conservative approach, the assumed rate is much lower than the existing money market return of 17%), we can see how regular monthly investments can lead to substantial returns over time.

There are many SIP calculators online that will help you design a SIP for your desired maturity amount.

Mr A, a 35-year-old investor, has decided to invest Rs25,000 per month in a low-risk money market fund for a 25-year investment horizon. At maturity, his investment would grow to Rs43.41 million on a principal investment of Rs7.5 million.

Similarly, Mr B, a 25-year-old investor, has also invested the same amount on a monthly basis in a money market fund. However, he has a longer investment horizon of 35 years, which allows for more time for compounding to work its magic.

At maturity, his investment would grow to Rs142 million on a principal investment of Rs10.5 million.

In conclusion, we can see that Mr B’s investment has grown substantially more than Mr A’s due to the longer investment horizon and the power of compounding. This example illustrates the importance of starting to invest early and allowing time for investments to grow through the magic of compounding.

Monitor your investments

Even though SIP helps manage risk, it is important to monitor your investments regularly to ensure that your investments are performing as expected. If required, rebalance your portfolio or switch to a different investment option or asset class, if it is not performing well.

It is always recommended to consult with a financial adviser who can guide you in selecting the appropriate investment options based on your risk appetite, financial goals, and investment horizon. They can help you understand the risks and benefits of investing through SIP.

It’s also important to note that actual returns on investments can vary and depend on market conditions, fund performance, and investment strategy. However, the concept of compounding remains a powerful tool for achieving financial goals.

The writer is SVP – Head of Shariah Compliant Income Portfolios at Al-Meezan

 

 

Published in The Express Tribune, April 10^th, 2023.

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