Understand the Power of Compounding

Power of Compounding

All of us have studied the formula of compound interest during our school days, and we can easily calculate it on our calculators or spreadsheets. There is a good chance that we even have a rough understanding of the definitions of compounding. But, the question of the hour is do we really understand the real Power of Compounding?

Understand the Real Power of Compounding

Before I give you all the interesting examples to understand the real power of compounding, please read this standard definition of compound interest - “Compound interest in the simplest of terms means earning interest not only on your principal amount but also on the interest earned, i.e. interest on interest.

Example - If a StockBasket says that in last 5 years it has earned a CAGR (Compounded Annual Growth Rate) of 15%, it means that every year you will earn 15% on your accumulated capital every year. Suppose you invested Rs. 100 at the beginning of year 1 then after 1 year it will be Rs. 115. Then in year 2, you will earn an income of 15% on Rs. 115 and not on Rs. 100.

Below is a table which shows how your money will “Compound” over the next 5 years -

Year Amount Invested The amount under
Simple Interest @ 15%
Amount Under
Compound Interest @15%
1 100 100 100
2 100 115 115
3 100 130 132.25
4 100 145 152.10
5 100 160 174.9

A difference of 15% in just 5 years and the difference only widens as time increases (covered later in the article).

Now that we have discussed the definition, here’s the formula which is used to calculate Compound interest -

A * (1+r)^t

A = Amount invested
R = Periodic Rate of interest
T = Period

Now that we are done with boring stuff, let's look at some really interesting examples/quotes.

Albert Einstein on Power of compounding

Albert Einstein has rightly quoted that “Compound interest is the eighth wonder of the world. He who understands it earns it, he who doesn't… pays it”

Let’s also take some wisdom from the legendary stock market investor Warren Buffett -

stock market investor Warren Buffett

One of the richest people in the world contributes his wealth to the power of compounding and understanding.

Okay, so one of the smartest people ever and one of the richest people currently speaks so highly of compound interest. I am sure now I have all of your attention and you must be keen to know why compound interest is so important.

To understand the power of compound interest solve this simple riddle -

How many days will it take Re 1 to cross Rs.10000000 if the amount were to double every day?

25 Days!!!! You read it right, it just takes 25 days for Re.1 to cross Rs. 10000000. On the 25th day, the amount becomes One Crore, Sixty-Seven Lakhs, Seventy-Seven thousand two hundred and sixteen rupees.

Interesting right? It gets more interesting. Here’s an example of Rs. 10,000 invested over different periods of time -

Rs. 10,000 invested today at an interest rate of 15% becomes 100,000 (10 times) in 25 years when compounded annually while it only becomes about 38,000 when calculated using simple interest.

The difference only widens when the time of investments longer and longer! Look at the difference when the Rs. 10,000 is kept invested for 50 years.

The difference is phenomenal when the amount is invested for a full 100 years.

Now, you must think it all looks good in theory and looks beautiful in the charts, but could it be done in reality?

The answer is YES. Look at the following chart which shows the Networth of Warren Buffett, it looks strikingly similar to the 100 years chart.

Networth of Warren Buffett

This is the power of compounding that I wanted you to understand.

Power of compounding, super-powerful right?

Now, let's understand how you can take this power to your investments! Follow these simple things to put the eighth wonder of the world at work grow your wealth -

  • Invest for long term (as long as possible)
  • Invest in equity markets (Great quality stocks only of course)
  • Start as early as possible (Warren Buffett started at the age of 14)
  • Live a very long life (Warren Buffett was 89 years old in 2020)

While all the steps are very important, step 2 - “investing in great quality stocks” is something that would require a LOT of time and efforts from an investor. Efforts and time in terms of thousands and thousands of pages of reading, millions and millions of data points to analyse and years and years of experience, constant monitoring of your investments and what not!

Seems like a very daunting task? Feels impossible to do? Don't worry, there are a lot of great financial advisors of portfolio managers or mutual fund managers who can help you with where to invest your money. One of such platforms is StockBasket. It is a platform where market experts have created mini-portfolios of great quality companies for you to invest in just a few clicks!! They have read thousands and thousands of pages analysed millions and millions of data points and have a combined experience of over 100 years. They constantly monitor your investments and try making the best return for you at relatively lower risks. These are buy and forget type of investment tool and probably India’s only purely long-term investment platform.

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