How 8-4-3 compounding rule can accelerate your investment worth thousands into crores; know maths

8-4-3 Investment Rule: Want to watch your money grow faster? The 8-4-3 rule is an investment strategy that harnesses the magic of compounding to accelerate your wealth accumulation. Through expert calculations, know how it works to help you achieve financial goals and accumulate a corpus running into many crores.

What is the 8-4-3 rule of compounding?

In the 8-4-3 strategy, the average return of a particular investment amount for 8 years is 12 per cent/annum, while after that time period, it will take only half of that horizon, i.e., 4 years (total 12 years), to get a return of 12 per cent. Similary, apply for the next 3 years (total 15 years), and your corpus will be doubled.

According to Adhil Shetty, CEO, BankBazaar, it’s a relatively new thumb rule that talks about how your corpus growth accelerates with time.

"On an average, the top 10 equity funds in India have generated about 14.5 per cent returns on a CAGR basis over the last five years." said Nehal Mota, Co-Founder & CEO, Finnovate. "To this, if you adjust the long-term capital gains tax of 10 per cent, we are looking at realistic post-tax yields of around 13 per cent CAGR," she added.

"Compounding, or compound interest, is the concept wherein interest accrues on the initial and past investment. The corpus, comprising the principal investment and interest earnings, accrues interest and is reinvested over a period of time, which can exponentially grow your wealth. This is also known as the 'snowball effect’ which can yield significantly higher returns over a long-term investment period." she said.

What are the strategies to get the maximum interest/returns?

Following these tips can be beneficial to getting more interest on your investment:

Early investment: By investing at an early age, your investment has time to maximise your returns.

Choose the right option: Some investments may have several compounding frequencies- some may compound annually, while others may compound quarterly or even monthly. Investments like mutual funds, tax-saving schemes, fixed deposits, and Public Provident Fund (PPF) are some schemes that provide compounding benefits.

Equity-long term: It is good to be invested in equities for the long term. For instance, equity funds have been very good wealth creators over the long run. On the other hand, it is tough to create wealth through bank FDs and money market funds.

Invest for at least 10 years: In this rule, real momentum of wealth creation starts after the 10th year, when the compounding effect generates more passive income than active income.

Up your investment: When your income rises, increase your investments to facilitate the compounding process.

Don't be in a hurry to withdraw profit: If you withdraw gains in the form of dividends, serious compounding is never likely to happen. But instead, reinvest them for the long term so that you can reap the maximum benefit of compounding.

Consistent: Compounding only works if you invest consistently. Consider automating your investments to ensure that they are made on time and on a regular basis.

Diversify portfolio: Stick to a diversified fund and avoid thematic funds like sectoral funds, small-cap funds, mid-cap funds, etc. At the end of the day, this game is about risk-adjusted returns.

Avoid market volatility: The most important rule is to ignore short-term volatilities in the market. There will always be noise in the market and as long as you are invested in a diversified portfolio of equity assets for the long run, you are on the right track.

ALSO READ | How this strategy can help you build a corpus of Rs 1.74 crore with an annual investment of Rs 1 lakh

How can the 8-4-3 rule convert Rs 7 lakh to nearly Rs 26 lakh; here's calculations:

Compounding operates in the same way as compound interest does over simple interest. In simple interest, you just get returns on your capital every year. However, under compound interest, you earn returns on (principal+returns) because all returns are reinvested. When all returns are reinvested in the investment, the returns are divided into two components: return on capital and return on returns. The latter is also known as passive income, and it holds the secret key to compounding.

Mota explained how much your Rs 7 lakh will grow in nearly Rs 25 lakh in 25 years:

 

In the table, you can see how an investment of Rs 1,00,000 in the first, third, fifth, 10th, 15th, 20th and 25th years will grow with returns of 14 per cent annually.

 

At the end of 3 years, the active gain is Rs 42,000 and the passive gain is Rs 6,154. After five years, active gain of Rs 70,000 is much higher than the passive gain of Rs 22,541. After 10 years, the active gain of Rs 140,000 is slightly more than the passive gain of Rs 130,722. The real magic of compounding starts reflecting after the 15th year, when passive income of Rs 403,794 surpasses active income of Rs 210,000. After 20 years, passive income of Rs 994,339 is much more than active income of Rs 280,000. After 25 years, passive income of Rs 2,196,192 is almost six times the active income of Rs 350,000.

When we accumulate the returns from active and passive income, we find that after investing Rs seven lakh, in 25 years, one can get Rs 2,196,192 only from passive income, which is actually the money that has come through compounding. With just Rs 350,000 from active, the total returns in those 25 years will be Rs 25.46 lakhs.

What if you invest Rs 30,000/month through SIP

Jiral Mehta, Senior Research Analyst, FundsIndia, explains that if you invest through a SIP of Rs 30,000 per month with average annual returns of 12 per cent, calculations will be as follows:

The infographic above, by MF platform FundsIndia, illustrates how an SIP of Rs 30,000 a month grows over a period of 24 years

The 8-4-3 Rule helps explain the power of compounding. An investment of Rs 30,000 every month with annual returns of 12 per cent, it takes eight years to reach your first Rs 50 lakh. But it takes just half the time, or just four years, to earn your second Rs 50 lakh, and for the third Rs 50 lakh, you need just three years. By the time you reach the 20th year, you are adding Rs 50 lakh almost every year!, she explains.

"This rule works for any SIP amount. This is the counterintuitive nature of compounding- it happens slowly and then suddenly" she added.