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Rishabh Shah

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“Compound interest is the 8th wonder of the world. He who understands it earns it….He who doesn’t pays it…. ” – Albert Einstein 

“My wealth has come from a combination of living in America, Some lucky genes and compound interest.”- Warren Buffet

The power of compounding is really important to understand if you want to make a lot of wealth. Warren Buffet arguably the most successful investor of all time is a great believer in the magic of compound interest. He has been preaching this for decades, which has made him a billionaire. He goes onto say that compound interest over a period of time can do extraordinary things. Take a look here for an example at Buffets net worth.

Net Worth of Warren Buffett

 The majority of his wealth has been accumulated in recent years. Going from $3.8Bn when he turned 59 to currently to a whopping $82Bn when he turned 89. This is the snowball effect. It is the rolling of a snowball down the slope on a snow-covered hillside. As it keeps rolling, the ball will pick up more snow gaining more mass, surface area and momentum as it rolls along. It is a process that starts from an initial state of small significance and builds upon itself, becoming larger. This shows the effect of compounding. 

Compound interest just means you earn interest on your interest. At a 10% a year simple interest, you earn Rs 1,000 on Rs 10,000 every year and have Rs 1,500 after 5 years. If you allow the interest to compound, that 10% compound interest gives you Rs 1610 after 5 years. It’s like you earn an extra year of interest. You don’t do anything but let your money work for you. As your money keeps working for you, it keeps gaining momentum and size. The more time it compounds, the larger it becomes. 

Now coming back to the example, If you invest at 10% compound interest for 5 years, your wealth increases by 60%. But if you invest at 10% compound interest for 50 years, your wealth increases by 11,639%. That’s a lot of wealth. All it takes is 10% and 50 years. The problem is many of us don’t have 50 years to retire. Therefore to take a larger benefit of compound interest, it is better for you to start as early as possible. 

Traditionally if you invest in stocks, you want the stock price to rise but the value of the portfolio will increase linearly to that rise in stock price, i.e if there is no compounding going on. If it’s a dividend-paying stock, you can more shares going along as you keep investing these dividends into the company. These results in compounding and those extra shares keep earning more and more money. The single biggest mistake that individuals and investors make in their life is that they don’t reap the full advantage of power of compounding. It is easy to understand this concept but very few people can actually implement it and reap its benefits.

Let’s take another example of 2 people Peter and Henry. Peter starts investing when he is 20 years old and just takes little bit of his money, locks it down and sets aside to invest it. Lets say he takes out Rs 20,000/month, which is 2,40,000/year and invests it in the stock market. Overtime he averages 10% returns post taxes. Let’s say he makes that investment till the time he is 40 years old (therefore he invested for a total of 20 years) and after that he did not invest a single rupee till he turns 65 years old. On the other hand Henry does not get started when he is 20 years old. He waits till he is 40. Let’s say he starts putting in the same amount of Rs 2,40,000/year, averages the same 10% return post tax and invests till he is 65 years old. He invests for a total of 25 years, therefore has put in more money in the system than Peter. 

At the age of 65, who do you think is doing better off? I know you know the answer, but the real question is how much better off. Peter who started earlier and quit earlier, who also invested for a lower number of years has 600% more money than Henry. At age 65, Peter has accumulated around Rs 14.89 crore, whereas Henry has accumulated around Rs 2.36 crore only (after having invested for 5 more years than Peter, the only difference being Peter started out early and let his money compound for a longer period of time).

I advise you all to start out your investment journey as early as possible to reap the benefits of compounding. To do this you can visit the Stockbasket application and buy a basket/portfolio of stocks specially made by research professionals just for you. You can choose your investment options from a variety of baskets available depending on your investment goals.

“Our favorite holding period is forever.”

Warren Buffet

How long should you hold a stock? Buffett says if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes. The benefit of long term investing in stock market is unparalleled, provided that investments are made in fundamentally strong companies with a good business model, sound management and growth visibility. Staying invested in the market over the long term has historically paid off. Let’s look at these benefits.

Cost effective:

Most of the market participants blow up a huge amount of money in commission, brokerage charges and various taxes by continuous trading in stocks. The more you trade, the more charges are triggered. Long term Investors will save on all these costs as it naturally leads you to transact less often. Every rupee saved can be further added to your investment capital, which makes long term investing very powerful.

Power of compounding:

“Compounding is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it” – Albert Einstein. The element of compounding comes into play during long term investments when your investments produce earnings through dividends, stock returns etc, they get reinvested in the stock and can earn even more. The more time you’re invested in a stock, the power of compounding gets larger.  Your investments can grow exponentially over time.

For example, let’s take two people, Ram and Shyam, who have the same starting balance say Rs 1,00,000 each. They both decide to buy same investment on the exact same day and earn the same interest of 10%. They both plan to hold their investment for 30 years. Ram plans to withdraw the interest at the end of each year, while Shyam plans to reinvest the interest and let it compound. Let’s fast forward 30 years and see the difference in the potential returns. Ram who withdraws the interest, would earn Rs 10,000 per year. Over 30 years, his earnings would have amounted to Rs 3,00,000. But let’s see how much difference reinvesting would have made. As shown in the chart below, Shyam who reinvested the interest would earn, Rs 16,44,940 above his initial balance which is more than 5x of Ram. This example illustrates the power of compounding. Long term investment takes advantage of the power of compounding and maximizes your returns.

Highly effective:

Long term investing works because it makes you focus on things that really matter. Long term investors will look at the core fundamentals of the company such as growth prospects, performance, management competency, etc and not look at the day to day fluctuations in stock prices. Over the long term, price movements tend to normalize depending on the performance of the business. Historically, these factors are much effective to predict future returns.

Removes the short term volatility out of the picture: 

The stock prices may show very high volatility, i.e, fluctuations in prices in the short term but maybe growing over the long term.  These fluctuations tend to confuse the investors as emotions take over leading to rash decisions.

The stock prices never go in one direction continuously without any fluctuations. As you can see in the above chart, there are several upward and downward movements in the price, but looking at the larger picture the stock is trending upwards. Long term investing helps investors ignore these short term fluctuations.

Requires Less time:

Long-term investing requires less of your time. Your work is done when you buy a stock which you think is of high quality and will maintain its competitive advantage over the years. All you have to do is to check periodically whether the company is performing well. Trading and short term investing require one to give full time and efforts to it.

No need to time the markets:

It is very difficult for someone to predict when to enter & exit the market consistently and accurately over various businesses or market cycles. You would be much better off to stay invested in the markets. Investors who try to time the entry and exit points tend to underperform the ones who stay invested throughout.

Fulfilment of long term goals:

Are you saving up to buy a house, fund your retirement or your child’s education? Long term investment is the way to go! To prepare for a high cost future, you should cut down your current costs and invest that money for the long term. The earlier you start, the compounding effect gets larger. You must be thinking which stocks to invest in for such long periods and whether the companies will still have strong fundamentals 5-7 years down the line. StockBasket is a product that will take care of this for you. It is a basket of high quality stocks, carefully chosen by experts. It helps you stay invested for the long term, without worrying about anything else. It keeps track of the portfolio and makes time to time changes if necessary Investors can choose amongst various baskets such as ‘Retirement in 2040, ‘4x target in 10 years’ depending on their goals and investment horizon.

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