By Medha Rijal
All of us have come across the power of compounding but very few actually do know it’s significance. Aging as old as the 17th century, compounding was considered as the eighth wonder of the world. As quoted by Albert Einstein,”Compound Interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it. Compounding is the most powerful force in the universe.” Let us check out the power of compounding.
Knowledge & Money Compounds
Warren Buffet has a net worth of over US $ 85.6 billion and is considered one of the most successful investors globally. He was quoted to state, “Read 500 pages everyday. That’s how knowledge works. It builds up like compound interest.”
If you ever have a discussion with an investment advisor, he or should would depict an exponential growth in your investments over the next five years. They would tell you investment opportunities where wealth builds by compounding.
In fact, this is one way we plan for our retirement, our child’s education other foreseeable events in the future.
This is the exact way empires were planned and sustained in the past whether the British or the Ottoman.
This makes it inherently pressing for a person to know what exactly is compounding and how can one make its best use.
What is Compounding?
Compounding is a powerful tool that can help exponentially grow your savings over a considerable period of time thereby changing the financial future for an investor.
It can be defined as a process where the interest earned on an asset during the first year is added back to the value of an investment to calculate the interest for the following years to come. It leads to a cycle of increasing interest and account balances at an increasing rate which leads to exponential growth.
Basically one generates more money from the money one has.
Compounding adds the initial returns that you have earned on an investment to the principal amount. The concept is based on the time value of money.
How does compounding works ?
Let us first analyse an everyday situation which we all come across.
- Shyam received INR 100 as salary.
- He went ahead and deposited it in his savings account.
- The bank paid him an interest of 5%, which amounted to INR 5
- He received INR 5 as an extra income for this year.
Now you could note that from the next year the power of compounding kicks in. From the next year onwards, the principal amount would be taken as INR 105 and the interest would be calculated on this principal. Similarly, for all the years to follow the cycle of compounding would continue.
What difference the power of compounding makes?
To understand this, let us analyze two approaches adopted by different investors:
Sita and Gita are two investors looking to invest in the market. They both have savings of 2 lakhs each and are looking for avenues to invest this amount. Basis, their analysis they come across an opportunity where they would earn a return of 10%, so they both decide to stay invested for a period of 10 years.
Sita goes for the option of Compound interest whereas Gita invests on the basis of Simple Interest.
|Simple Interest||Compound Interest|
|Duration ( years)||10||10|
|Rate of Interest||10%||10%|
|Amount at Maturity||4,00,000||5,18,748|
Sita earns an additional corpus of 1,18,748 in comparison to Gita, who opted for Simple Interest.
Leveraging the power of compounding in real life
Rule of 72
Suppose you want to double your money by investing in an asset which gives 12% p.a. compound interest.
Now in this case it would take, 72/12 = 6 years to double your money.
This means when you your money in a bank account which gives 4% p.a. interest, it would take 18 years to double.
By making a a FD at 6% interest rate, it takes 12 years. You saved 6 precious years of your life.
On the other hand, suppose you want to double your money in 2 years, in this case, you would to invest at 72/2 = 36% p.a. compound interest.
Start compounding early
If you want to leverage the power of compounding, start early.
Compounding works on the principle of the time value of money. As per the concept, any sum of money that you receive in today’s time is more valuable than the future value of this deposit. In other words, it means that money received today has more value than money you would have received in the future due to the opportunity costs associated with it.
The crucial part of compounding is the window of investment that investors keep their deposits for. The earlier you start the window of investment, the higher would be the returns, thereby leading to greater investments. Let us study an example here to understand the importance of time while making an investment:
Sam opens an Individual Retirement Account at the age of 18. He contributes INR 20,000 for a period of 10 years with an average growth rate of 10%. After a period of 10 years, he decides not to make any more investments.
Similarly, Pam opens an Individual Retirement Account at the age of 26 and thereby contributes INR 20,000 till the age of 65. The average growth rate for his investments are 10%.
If you were to compare the results of the two, you would notice that Sam earns a higher return on his investments even though he only invested for a shorter investment window.
The early bird catches the worm. The earlier you start investing, wealth accumulation would only get better. It has been observed that investors who invest early are able to plan their current expenses in addition to planning their retirement.
Small change can make a huge difference in compounding
The rate of interest which you earn on an investment determines the compounding effect that it would have. Therefor, it is important to accurately choose the investment avenues you wish to choose from.
For example, with a different rate of interest, an investment of 1 lakh would fetch different returns over a period of 10 years.
|Investment Instruments||Growth Rate||Amount on Maturity|
|Mutual Funds – Debt||10%||2,70,704|
|Mutual Funds – Equity||14%||4,02,247|
Patience & compounding are the pillars for building wealth
The returns of an investment would fetch you profitable returns if you invest a considerable amount and let it compound for a considerable period of time.
Majority of investors invest in an ad hoc manner leaving them incapable of reaping maximum benefits from the investment. You would only get a considerable profit from your returns if you keep the corpus invested for a considerable period of time.
The power of compounding can help you financially independent early. It just requires discipline along with a positive attitude in the early years. There are no extra ordinary talents needed.
The only thing you need is to invest early and consistently. Compounding has the ability to move mountains, for you, if invested correctly.
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This article is authored by Medha Rijal. She is an active blogger and writes about topics such as financial planning, investments and wealth management.