Educating Investors

Power of Compounding4 min read

“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.

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