Investment Shastra

How the Magic of Compounding works?

‘Compound Interest is the 8th wonder of the world. He, who understands it, earns it; he, who doesn’t pays it!’ – Albert Einstein

Compounding means re-investing earnings from an investment back into the investment itself. It means you earn interest on the interest too. And, this magnifies the return you can earn—exponentially! Successful investing means growing your money through compounding—your entire Investable Surplus. You don’t need to take high risk or expect 20% returns, you need to allow the compounding to happen.

To allow compounding to make its magic work on your investments, do these 3 things,

1. Have patience!   

Look at this graph. If you invest 1 lac and allow it to compound at 12%, you will have Rs. 3.1 lacs after 10 years, Rs. 9.6 lacs after 20 years and Rs. 30 lacs after 30 years. In the 1st 10 years you earn Rs. 2.1 lacs, the 2nd 10 years period Rs. 5.5 lacs and in the 3rd next 10 years Rs. 20.4 lacs! And, the earnings will go on increasing exponentially! So, have patience, allow compounding to work.

Compounding-Have patience

2. Start early!
In compounding, when you start saving outweighs how much you save.

This graph shows how much you need to invest every year at 12% to reach Rs.5 Cr at the time of your retirement at age 60. Just Rs. 60,000 at the age 20, and it becomes 10 times more, if you start at the age 40! So, with pretty decent income and with a little self-control on spending you can start investing early and end-up with a big corpus when you retire!

There is one more advantage: If you start early, you can stop early too! Look at this graph.

Compounding-start early

If you invest Rs. 1 lac every year from age 20 to 40, at 12%, then by 60 you would get Rs. 7.8 Cr. If you started 10 years late, invested from age 30 to 50, you would get Rs 2.5 Cr—and from 40 to 60, just Rs. 71 lacs. In all cases, you would have invested for the same 20 years! So, what changed? You allowed the compounding to start early!

So, does it mean that if you are older, say 45, you have missed the bus for compounding? Fortunately, not yet! At 40 even 50 or more, you still have many years—as people live longer now— during which you can compound their money at a good healthy rate. You must immediately invest your lumpsum Investable Surplus sensibly at a higher rate of return.

But, don’t do any reckless investments in the hope to make up lost time. You cannot risk losing your capital, and don’t have time on your side to recoup some poor investment decisions. Also, you need to start committing as much as you can from your current monthly saving. With proper asset allocation, it is very much possible for you to secure your future, and even fund your dreams.

3. Start with as much as you can, and increase contribution every year!

If you invest Rs. 50,000 every year for 40 years at 12% interest, you will get Rs. 4.3 Cr at the end of 40th year. And, if you increase your investment amount by another 6% every year, you can get Rs. 7.7 Cr! So, increase your investment amount every year!

To conclude, the most powerful force in the universe is compound interest. So,

  • Start early
  • Invest consistently, and increase your contribution
  • More importantly, have patience!

See this interesting story to understand ‘Power of Compounding’

Advanced reading:

  •  https://www.investopedia.com/walkthrough/corporate-finance/3/discounted-cash-flow/compounding.aspx
  • https://www.tonyrobbins.com/ask-tony/power-of-compounding/

Try Compounding Calculator:

https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

Read the next article to understand ‘Why it’s important to commit to the long term investing?

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