“Compound interest is the eighth wonder of the world.”
– Benjamin Franklin
“In case you earn Rs20,000 per month, do you know how many years it will take you to become a crorepati? Not 10 or 20, but 50 years!” Have you heard Amitab Bachchan while anchoring “Kaun Banega Crorepati” some years back.
Mr Bachchan, do you know that if you invest just Rs.9,250/- once and earn 15% per annum on this investment then, in 50 years you too can become a crorepati?
And in case you invest Rs.20,000 every month for 50 years under similar terms, you will be worth more than (hold your breath) Rs173 crore! That is crorepati 173 times over!
Welcome to the power of compounding
One of the basic premises of investing is that your money multiplies manifold over time and this multiplication of money is normally referred to as the “Power of Compounding“.
So, how does money compound?
When you invest money, it earns interest (or returns, if you may) for you. If you keep the interest invested, then it does not sit idle while only the original investment sweats it out. The interest earns interest too and then the interest on the interest earns interest again!
What does the power of compounding mean to an investor? Let us understand this with the help of an example.
Ms Thrifty, Mr Realist and Ms Follower went to the same school and the same class.
On her tenth birthday, Ms Thrifty’s father gave her Rs100. She wisely invested the money that earned her an interest of 15% every year.
Mr. Realist won Rs.200/- as prize money when he was 16 years old. His friend, Ms Thrifty, advised him to invest his prize similarly.
When Ms Follower earned her first salary at the age of 21, she salted away Rs400 in the same instrument as Ms Thrifty’s.
After reaching the age of 60, all three decided to withdraw their investments. Who do you think realised the most from his/her investment?
You think it’s Ms Follower, right? After all, she invested four times the sum that Ms Thrifty had invested. So what if she had invested the money ten years later? She did earn interest for 40 years after that.
But think again. Ms Thrifty made the most out of her investment! In fact, her Rs100 was worth Rs108,366. On the other hand, Ms Follower’s Rs400 was worth Rs93,169! It simply means that the LONGER you stay invested the MORE you make. Now you know why Ms Thrifty made more money than Mr Realist and Ms Follower.
Let us try another small exercise.
Let us assume Ms Thrifty, Mr Realist and Ms Follower invest Rs100 for ten years. However, all three of them earn interest at different rates. Ms Thrifty earns 20% while Mr Realist earns 15% and Ms Follower manages a 10% interest rate.
Can you work out what each one of them will have ten years hence?
Ms Thrifty will have Rs619 while Mr Realist will have Rs405. Ms Follower will have the least–Rs259–in ten years. Have you noticed something though? While the interest rates differ by just 5%, in ten years the worth of the original capital, Rs100 would be vastly different.
That is another way of understanding the power of compounding or the power to grow exponentially.
Now that we have understood the magic of compounding, it is time to take a look at an interesting rule associated with compounding: The rule of 72.
The rule of 72 is an easy way to find out in how many years your money will double at a given interest rate. It is simple really. Divide the number in the title by the interest percentage per period to get the approximate number of periods needed for doubling.
Suppose the interest rate is 15%, then your money will double in 72/15= 4.8 years. In case, the interest rate is 20%, then the money will double in 3.6 years.
Interesting rule indeed!
Moral of the story: The longer you stay invested the more you make!
The power of compounding when applied to the stock market can make you a crorepati many times over and sooner than you can imagine. That is because historically, the stock market is known to give the highest return per annum compared with the other investment instruments.
We provide Investment ideas to our clients. Invest in them and then sit back and watch the power of compounding weave its magic over your investment.
If you don’t have an exposure to the stock market yet, start right now as according to the power of compounding, the longer you stay invested the more money you make.