“Sometimes I think that having ten million in my account will remain just a dream. I have been saving 40% of my take home salary for last couple of months. However, even at this rate, it will take another 14 years for reaching the magical figure. I should have started from my first day in job”, said my friend Aaditya.
“That’s a great savings rate! What would you need this money for? Is this target for your savings account?” I asked.
“Does it make a difference? It will still take 14-15 years, right? I am sure that by then this amount would not mean much. It would take another life to become wealthy”, he sounded a little disappointed.
“Do you know about compounding and that Albert Einstein called it the eighth wonder of the world?”, I asked and then our discussion continued.
When the greatest living investor says something, we need to pay attention. Warren Buffett has said:
“My wealth has come from a combination of living in America, some lucky genes and compound interest”
If you have not experienced the astounding power of compounding yet, check your PF balance. See for yourself how the interest gets added to the principal in the second year and earns interest. This amount (principal+interest) earns interest again next year and this goes over and over.
The best part is that you do not have a role to play-compounding is a waiting game. Longer the wait, the better it is.
I received my first real lesson in the power of compounding few years back when my ‘not a very big’ investment in Equity Linked Savings Scheme (ELSS) had given me a return of 126%, by the end of sixth year!
It is not difficult to understand, but is the most ignored and a rarely used concept in personal finance. We all have studied compound interest early in school, some happily, most others, with the objective of just passing through!
If you are reading this and happen to be a-
Teacher – if there is only one practical lesson (related to finance) that you want your students to part with, make them understand Compound Interest
Parent– teach your child the concept of Compound Interest but make sure you understand it first
Student– this one factor will solve most of your future money issues
Professional just starting a job– put your money in an investment which compounds it at a decent rate and you will thank yourself for this action many years from now
We all know the formula, but let us go through it one more time:
P=Principal or the initial corpus invested
r= rate of interest
t=number of years
Numbers look realistic when the calculation is easy. Open a sheet in MS Excel and input values as highlighted here:
|P (Principal or initial value)||100000|
|r (Rate of interest)||12%|
|Future Value (FV) or Amount||Rs. 9,305,097|
An investment of INR 100,000 can become INR 9,305,097 at 12% in 40 years. This is for a single, non recurring investment. In case of regular periodic investments, the result will be quite different.
Here is another snapshot which demonstrates the impact of time and rate of return on a portfolio:
|No of Years||4%||8%||10%||12%||16%||18%|
- Just a onetime investment of INR 100,000 can grow to INR 11,739,085 in 50 years @ 10%. This is the impact of compounding.
The rate, at which Aaditya is saving, would make him a multi millionaire at a much faster clip. (Provided he stays disciplined and invests for the long term at a decent rate)
- A sum of money compounding at low single digits would not make a huge difference even after 50 years. As per the rule of 72, at a rate of 4%, an investment doubles in 18 years. So money should be invested in avenues which offer a good rate of return.
- The wondrous power of compounding is at display in the later years. Notice the difference in the amounts after 30 v/s 40 v/s 50 years at any given rate. This is the snowball effect.
- A difference in rate of even 2% can make a marked difference to the corpus. Thus asset allocation for maximizing returns is very important.
The problem with any market related investment is that we cannot visualize our money going through ‘cycles’. If there is a down cycle, the fear of our investment going below the original value sets in. If there is an upward trajectory, we want to book the available profit in the first instance.
Compounding is like sowing a seed and then nurturing it, till it bears fruit. This takes time. We just need to protect it from extremes (volatility), water it regularly (discipline), add manure (step up the amount) in between and watch it grow.
1 Start investing early- nothing works better. But if you haven’t yet, start today-you will still be able to write your compounding story. Do not wait for accumulating a particular amount for lump sum investments. Any amount you are comfortable with every month should be the starting point.
2 The long term corpus should remain sacrosanct
3 There will be trends and fads- do not get swayed and move your investments from one fancy product to other (Bitcoin is the latest example)
4 If your retirement goal is years away, it would be the best area where the amazing magic of compounding can be put to use. A 25 year old would have 40 years to create a retirement corpus, which might outlast him/her. The next generation would appreciate such foresight and discipline!
5 Continuous buying and selling involves charges and taxes to be paid and thus long term compounding is compromised.
Charles T Munger aptly said-“The big money is not in the buying and the selling, but in the waiting”
6 Compounding is a great equalizer, whether you invest INR 5,000 per month or INR 50,000. However, remember that 10% of INR 1,00,000 is INR 10,000 and 10% of INR 100, 00,000 is INR 10,00,000! So, higher the money invested, greater will be the corpus.
Your dislike for mathematics and formulas should not keep you away from multiplying your wealth!