Good Morning Avantika,

Some lessons bear repeating, they’re just that important. 

When it comes to building nice, chunky corpuses, there are few factors more beneficial than the magic of compounding. It’s even been called the eighth wonder of the world. 

Last week, I wrote about how tax deferrals can be used as a tool to eke out better returns from cumulative deposits. This works because putting off tax payments until you actually receive the interest in hand exposes the entire sum to the full benefit of compounding. 

But not all deposits on offer are cumulative, and knowing which is which can go a long way towards designing a better investment portfolio.

The forever magic of reinvesting

Cumulative deposits are wealth ‘compounders’. 

Not only does the original investment earn interest, the interest does too. 

The interest earned from a cumulative deposit during a particular period—say a quarter, half-year, or year—is reinvested and earns interest for all the remaining periods until maturity. 

Interest on interest, as it were.

Here’s some straight math. 

Let’s say you start a 3-year cumulative deposit of Rs 1 lakh (~US$1,250), at 7% annual interest. The Rs 7,000 (US$90) you earn in the first year is reinvested and earns another 7% interest for the next two years, and so on. This keeps happening at the end of every period until the day of maturity. 

In the case above, the amount you’d get at the end of three years would be Rs 1,22,504 (US$1,540). 

Not every investment option in front of you these days is cumulative though. There are many, some quite popular, instruments that pay out interest income at regular intervals instead of ploughing it back for a full dose of compounding. 

The floating rate savings bonds (FRSBs) issued by the RBI come under this bracket; so do government securities (G-secs) and the post office’s Senior Citizens Savings Scheme (SCSS). Such instruments have their uses. If an investor needs regular interest income to meet expenses, then the payout structure of these products is just fine. But if your objective is to grow wealth, it’s hardly optimal. 

Because if, in the above example, the interest wasn’t reinvested, the payout at maturity would be only Rs 121,000 (US$1,520). That’s a difference of Rs 1,500 (~US$20) between the cumulative option and non-cumulative options—nothing to be scoffed at. 

This difference will balloon for every rise in total investment and tenure, and interest rate. 

Banks and many other financial institutions allow investors the option of choosing between cumulative and non-cumulative deposits, but there is no such choice for instruments such as the FRSB, SCSS, and G-secs. By default, the interest is paid out on these investments—half-yearly in FRSBs and G-secs, and quarterly in SCSS. 

Does this mean these investments don’t make the cut? No. 

On the contrary, these are among the best fixed income instruments in the market—with very low risk thanks to government backing and a relatively high interest rate (currently 7.15% for FRSBs, 7.4% for the SCSS, and ~7.1% for the 10-year G-sec) compared to many bank deposits. 

But, investors looking to grow their corpus will have to take the trouble of reinvesting the interest on their own. Because if you don’t do this rather religiously, there is a chance that the money could just be spent away. So take your interest earnings and put them to work again, either in the same instrument or comparable ones, as the case may be. 

There is a certain amount of reinvestment risk you’ll have to make peace with, though. This essentially means that the rate of return at which the interest income can be reinvested is lower than the original rate—like, for instance, if bank FD rates fall from 7% to 6.5%. In this case, the reinvested interest will earn less than before. 

But reinvestment risk can also work in your favour, if interest rates rise. 

This applies for other kinds of investments too, not just deposits. 

Dividends from stocks, for instance. You can deploy your earnings here as you choose, depending on the many options available and your risk appetite. There is no compulsion to invest the money back in the same stock that earned you the dividend. And there are mutual funds, of course, which come with both the dividend and growth options.

Go for the growth option if you seek to build a corpus, because the dividends and interest will be automatically reinvested in the mutual fund scheme. If you choose the dividend option, like with non-cumulative deposits, you will have to decide what to do with the money you get: spend it or plough it back. 

Reinvestment may take some effort. But it’s worth it. 

That’s a wrap for this week. Write to kaching@the-ken.com with your thoughts and suggestions, we’d love to hear from you. 

See you next Thursday!

Regards,

Anand Kalyanaraman