ARC: A simple formula to build wealth

The longer you are invested in growth assets, the more you earn returns and the more your returns generate additional returns.

One of the most important pieces of financial planning wisdom was given by Charles Jaffe: “It's not your salary that makes you rich, it's your spending habits.”

In a sense, that forms the cornerstone of planning finances and increasing wealth. When we asked ChatGPT about the three essential building blocks of financial planning, the answer was: discipline, patience and commitment.
While the answer is intuitively correct, it is too generic to be actionable. What is needed is a workable template that can help investors and young aspirants to create wealth in the long run in a safe, sure and aggressive manner. It is called the ARC formula.

The ARC formula
ARC is an abbreviation for the three steps needed to create a solid financial plan and ensure that wealth grows in a systematic manner.

“A” is for asset allocation, the first step to deciding how much money goes into various assets.

“R” is for regular savings. Savings have to be squeezed out of income, otherwise it will not happen, and it must be consistent. This is what’s needed to run this plan consistently for 20-30 years. Regular savings manifest through systematic investment plans, which not only instil savings discipline but also reduce the cost of holding through rupee cost averaging.

“C” is for compounding. The longer you are invested in growth assets, the more you earn returns and the more your returns generate additional returns. In compounding, the number of times you contribute is regular contribution while the length of time spent in the asset is compounding.

Importance of asset allocation
Empirical studies have proved that the bulk of returns over time are generated by asset allocation. But what is asset allocation? Typically, assets are classified into growth assets (equity and realty) and preservation assets (gold and debt). Ideally, young people should invest 70-80 percent in growth assets and 20-30 percent in preservation assets. This ensures long-term value growth with safety brakes fitted.

Ideally, the longer the time to your goals, the more one should invest in equity and growth assets and the less into debt and gold. With age, risk appetite and risk tolerance reduce and accordingly, the portfolio can shift more towards preservation. Any prudent portfolio needs growth and preservation, although for wealth creation, the former must dominate.
As legendary investor Ray Dalio summed it up: “You should have a strategic asset allocation mix that assumes that you don't know what the future is going to hold.”

Also read: Eight financial changes that may impact you this September

Regular savings
People normally define savings as the excess of income over expenditure. That is a very passive definition. If you wait for savings to happen, it never will. You have to make savings happen and that means prioritising expenses.

You will be surprised how much of savings you can eke out of your income if you cut the spillages. But maximising savings is just one part. You must also persist with regular savings. That is not easy. We are talking about savings to the hilt over a long time, especially when there are several spending temptations.

If you persist with savings for longer, even a small amount set aside regularly can grow into a substantial sum. For example, if you save Rs 10,000 per month in a mutual fund offering 12 percent CAGR returns, at the end of 25 years, you could be sitting on Rs 1.9 crore.

What’s more, you would have contributed just 16 percent of this amount and 84 percent would have been generated by the market. That is the power of regular, disciplined, and consistent savings.

As John Maxwell summed it up: “A budget is telling your money where to go instead of wondering where it went.”

Compounding, the final frontier
Compounding is when the principal and the returns generate additional returns over a longer period of time. Without compounding, the first two steps will only do half the job. You need to be invested in growth assets for wealth creation in the long term.

Even if you put money away in a money market fund for 25 years, there is only so much you can accumulate. You need to be in growth assets like equities and realty.

Also see: Buy-and-hold: Mutual Fund schemes that churn the least

Just look at the BSE Sensex. The benchmark index moved from 100 in 1979 to 67,000 in 2023. That is consistent compounding of 15.94 percent annually over 44 years. If you add the average dividend yield of 1.5 percent on the Sensex, we are talking of consistent compounding of 17.44 percent annually over 44 years.

A word of caution. Equity returns including the Sensex’s returns, are never linear. Hence, time spent in the asset is your hedge against volatility.
As Jeremiah Say put it, “Compounding is not just about money. It shows that small consistent efforts can generate remarkable results over the longer term.”