Wealth wisdom of the day: 'Understand not only the magic of compounding long-term returns, but the...': Crucial money lesson for investors from the 'Father of Indexing'

It’s almost certain that anyone who has stepped into the personal finance space would have heard of the widely popular compounding quote – “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” The saying speaks volume about the power of compounding.

It, however, leaves out one crucial point, which John Bogle, American investor and the founder of Vanguard, has cleverly highlighted.

For the uninitiated, Bogle founded the Vanguard Group, which transformed the mutual fund industry greatly, by making investing more accessible and affordable for investors. While he did propel and speak in the favour of compounding, Bogle also underscored a key detail that most investors looking to build their wealth gradually tend to miss out.

Wealth wisdom of the day: 'Understand not only the magic of compounding long-term returns, but the...'

Universally known as the ‘Father of Indexing’, Bogle had introduced the first indexed fund for individual investors in 1976. So, when it comes to compounding, it won’t be wrong to assume that Bogle knew what he was talking about when he said that investors also need to know a crucial detail beyond the magic of compounding.

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How would you feel about losing a big chunk of your compounded money being gone in some costs? Well, this is exactly what Bogle told investors to watch out for, beyond the magic of compounding.

“Investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs; costs that ultimately overwhelm that magic,” he said.

Compounding costs: What does it mean?

When it comes to investing and growing wealth, even small costs can have a big impact on your corpus. For instance, the seemingly small ‘brokerage fee’ you pay on your demat account or a ‘redemption fee’ that could be charge when you decide to withdraw your investment.

The best way to understand compounding costs is the ‘exit load’ and ‘expense ratio’ in mutual funds. While the exit load is a fee which mutual funds charge when an investor withdraws or sell their MF units before a specified time period, the expense ratio is an annual fee that the fund charges for managing your money.

Both these charges, which appear to be pretty small (0.5%, 1%, or 2%), but can significantly drain your corpus.

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Compounding costs: Exit load, expense ratio, brokerage fee impact on your investment

Take the case of expense ratio first, since it is charged annually. If your fund possibly generates 12% annual returns but has a 1% expense ratio, you will get an actual return of 11%. And even a 0.5% difference can create a huge gap over a long period of time due to the compounding effect.

Consider that you invest Rs 10 lakh in two mutual funds, both giving an annual of 12%.

Fund A has a lower expense ratio, say 0.06%. After a 20-year period, your total investment would multiply to around Rs 95.43 lakh. In this case, the expense ratio cost you approx. Rs 1.02 lakh, which is the opportunity cost over 20 years.

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Now, let’s assume that Fund B charges an expense ratio of 0.5%. After 20 years, your investment would grow to about Rs 88 lakh, and you would lose out on around Rs 8 lakh because of the higher expense ratio.

Similarly, even a slightly high exit load or brokerage cost can bring down your compounded wealth.