Techno Finance and Executive Diary...

Wednesday, November 12, 2008

Power of Compounding

Power of compounding

"Compound interest is the eighth wonder of the world"
- Benjamin Franklin

"Compound interest is the world's greatest discovery"
- Albert Einstein

"In case you earn Rs20,000 per month, do you know how many years it will take for you to become a Crorepati? Not 10 or 20, but 50 years!" exclaims Amitabh Bachchan, the anchor for "Kaun Banega Crorepati".

Mr Bachchan, did you know that if you invest just Rs9,250 once and earn 15% per annum on this investment then, in 50 years you will be a 'Crorepati' too!

And in case you invest Rs20,000 every month for 50 years under similar terms, you will be worth more than (hold your breath) Rs173cr! 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). 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 interest earns interest again!

That is the beauty of compounding. That is what made great men like Albert Einstein and Benjamin Franklin extol the virtues of 'compounding'.

What does the 'Power of Compounding' mean to an investor?
Ms Thrifty, Mr Realist and Ms Follower went to the same school and the same class.

On her 10th 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 Rs200 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 investment.

After reaching the age of 60, all three decide 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 money that Ms Thrifty had invested. So what if she invested the money 10 years later. She did earn interest for 40 years anyway after that.

But think again. Ms Thrifty makes the most out of her investment! In fact, her Rs100 is worth Rs1,08,366. On the other hand, Ms Follower's Rs400 is 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 10 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, Rs405. Ms Follower will have the least - Rs259 in ten years. Did you notice something though? While the interest rates differ by just 5%, in 10 years the worth of the original capital, Rs100 was 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. Lost?

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!

Labels: Business Lessons, Stock Market

Posted by "CPerformance" :: 12:37 PM :: 0 comments