Power of Compounding
Power of Compounding
The great Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it.” ... When you get into high interest debt, you are now fighting against the inevitable force of compounding
Basis my interaction of some of the small investors, some common question which I keep getting, they are as follows:-
Question: How do create wealth when I don’t have enough money to invest in Stock markets?
My answer: this is one of the most tired and overused excuses that people think they don’t have enough money to make good money in the stock market. The truth is you don’t need that much, if you understand the power of compounding.
Basically, compounding requires two things: The reinvestment of earnings and time. If we don’t reinvest what we generate is just a simple interest and if we don’t give it enough time then the ability of compounding is nullified.
Let’s look at the table below:-
1 rupee invested at various interest rates compounded for over 40 years clearly shows us the variability in earnings over a long run. For instance, At 5%, your investment would become 7x in 40 years wheras your investment can become 7523x if it grows at 25% returns yearly. To understand in detail, Pls refer the table given below
@rate
3 years
5 years
10 years
15 years
20 years
25 years
30 years
35 years
40 years
5%
1.2
1.3
1.6
2.1
2.7
3.4
4.3
5.5
7.0
10%
1.3
1.6
2.6
4.2
6.7
10.8
17.4
28.1
45.3
15%
1.5
2.0
4.0
8.1
16.4
32.9
66.2
133.2
267.9
20%
1.7
2.5
6.2
15.4
38.3
95.4
237.4
590.7
1469.8
25%
2.0
3.1
9.3
28.4
86.7
264.7
807.8
2465.2
7523.2
That is why compounding is a greater teacher of patience, Well for one, you don’t see results overnight. In fact, compounding interest is actually pretty boring, it can be like watching paint dry.
Q2 : What do the wealthiest and wisest investors have in common?
My Answer: Well. They are always smiling, because they are making money every second of the day. The so called rich people don’t have any bigger advantage in the market than poor people do.
That’s the power of compounding. Nothing can stop it from growing. As long as an investment is growing at particular rate, you can keep smiling at night, because you know that time is your ally. The longer time goes, the richer you get!
One of the best pieces of advice my mentor gave me when I first started investing in 2005 during my stint at SBIMF was simply this: “Invest the same amount every month.” Start your systematic investment plan. The early you do it the better it is.
Q: What is Rule of 72 :
The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself
For example, using the rule of 72, an investor who invests Rs. 100 at an interest rate of 8% per year, will double their money in approximately 9 years.
Formula: 72 / (periodic interest rate) = number of years to double principal
In the above example: 72/8 = 9 years. Let’s look at the table given below :-
Interest Rate
Rule of 72
No of Years to Double
5%
72/5
14.4
6%
72/6
12.0
7%
72/7
10.3
8%
72/8
9.0
9%
72/9
8.0
10%
72/10
7.2
15%
72/15
4.8
20%
72/20
3.6
25%
72/25
2.9
In fact, If you ask any person older than you what they wish they had more of, chances are they will tell you they wish they had more time, bcos truly understand the power of compounding
Happy investing!