Few days ago my daughter was reading a story that went like this….A man who invented the chess board brought it to the king. The king was happy and wanted to reward him. He asked the poor man how should he be rewarded? The man told him that there are 64 squares on the board; consider them as 64 days and for the next 64 days to give him one grain of rice from day 1 and double it each day. The king immediately agreed and smiled at the man’s foolishness. On the 15th day the store keeper came running to king and stated that the warehouse was getting empty… astonished as the king was, he called for the best mathematician to lay down the count of the grains by the end of 64th day , the amount was 18 million trillion grains. My daughter actually removed her calculator and started with the calculation, she shouted Mom “This is amazing, the man was not foolish at all. He was a genius” She questioned me if this can be done with money. I then explained to her the power of compounding; Albert Einstein called it the most powerful force in the universe. He said it was the eighth wonder of the world.
One of the most important things to know about investments is to understand and appreciate the power of compounding. It works on two principles, re-investment and time.
Money when invested in any financial instrument, earns interest. Interest earned is dependent on various factors, the amount invested, the rate of interest, and time. The amount may earn a simple interest or a compound interest. Simple interest is paid just on the principal, whereas the compound interest is paid on the principal plus the interest earned every year. Let us consider if the amount of Rs.10000 invested for 10 years, at rate of 10 %, the amount of interest earned as simple interest will be Rs.10000, whereas the amount of interest earned when compounded annually is Rs.15937. An increased earnings of Rs.5937. In other words compounding is re -investment of income at the same rate of return, constantly growing the principal amount year after year.
Another factor to be considered, is the interest rate. Let’s look at this : What happens to the amount of Rs. 10000 if invested for a period of 10 years, at a differential interest rate of 10% , 11% and12%.? The returns would be as under –
A smallest rate difference can make a big impact on the investment which cannot be overlooked. Compounding in reality gives legs to your money.
The third and perhaps the most important factor that adds the magical power to your money, is time. The longer the investment period greater is the strength of your money. It’s just like , older the wine, the better is it’s tastes. Let’s look at the table below:
|No of Years||Rate of Return 10%|
Thus, you may have realised that TIME is the magic wand for compounding.
Now let’s look at periodic investments. Consider investing in small amounts of Rs. 5000 per month for next 20 years @ rate of 12%. Your corpus will be 50 lacs. This is not just the work of the calculator but the money working for you. In these 20 years you may take a holiday, you may be away from work, but your money will be working for you. Money invested rightly can be an earning member of your family. These small investments can go a long way in meeting your life’s goals of retirement, education or perhaps help you celebrate your 25th marriage anniversary on a cruise! Celebrate the power of compounding. So Invest small, begin young and get wealthy!
The wonder of compounding is to make your money work, to transform it into a state of art, highly powerful income generating tool. The biggest difference between the wealthy and not the wealthy is that, one makes money work for them and the other works for money. The wealthy earns interest and other pays interest.
There are always two sides to the coin. Look at the effect of compounding when you borrow. It can be at its worst. Any delay in your credit card payments or EMI ‘s on personal loan, housing loans not only bring down your credit rating but also make a hole in your pockets. Thus the banks or other financial institutions use the power of compounding against the customer.
The power of compounding works for you when you invest and works against you when you borrow.