Compounding — A (not so) secret recipe

Albert Einstein once famously said , “Compound interest is the 8th wonder of the world.”

He saying it should be enough to believe it, but if one does not understand how deep this go, this little wisdom is of no practical use. Not that we understand all that Einstein said, but the other things just kind of play in the universe and help us.

This one play positively only for those who understand it. And negatively for everyone else.

We all gave up on compounding the day we were first taught its formula in school, right? That’s because first we are taught a simple formula of “simple interest”. And we are like, “Okay, this is easy. I got it” But then they go ahead and introduce a complex formula and we roll our eyes and make faces and break pencils and mug it up and vomit in exams.

Done and dusted! Never to look back at it.

That, right there my friend, is where we miss the magic.

What is compounding?

Compounding basically is intensified effect. There is a formula to it yes, but that’s for finance. Compounding is everywhere else too — relationship, health and knowledge!

The underlying ingredient in this secret recipe is to keep doing, consistently. To re-invest the benefits back into doing it more. And there will come a time when the process will intensify the outcome to exponential levels!

Take health for example. You start going to gym. It is difficult and if you keep going consistently, you start losing some fat. You have more energy(benefit) that if re-invested into working out more consistently helps you become fitter and more energetic that intensifies your workouts further. And you keep doing it and see the benefits on your body for years to come.

The thing is you have to be consistent, even after benefits start showing. Specially after benefits start showing.

It is the same story with learning a new skill, new subject, new activity. You just get better at it if you keep at it consistently.

Why is it so important in investing

The main concept of compounding is to re-invest the returns. That’s when compounding takes place.

In investing, compounding helps money grow.

Suppose you invest Rs 1 lakh in a fund that gives you 8%. At the end of 1st year, you will have Rs 1 Lakh (principal) + Rs 8000 (interest).

Now let us see, what happens if you decide to reinvest this 8000 as against if you decide to withdraw it. We will assume this 1 lakh stay invested for 20 years.

In case of no compounding, you will keep 1 lakh invested and withdraw the Rs 8000 interest earned every year. At the end of 20 years, you would have withdrawn 8000*20 = 1.6 lakh. At the end of 20 years you will withdraw your principal too. So your 1 lakh basically grew to Rs 2.6 lakh in 20 years.

This is simple interest.

Now let’s see what happens when you allow compounding, that is, you don’t withdraw the interest and re-invest it.

At the end of one year, you will have Rs 1.08 lakh. Because you have reinvested it, now the 8% interest will be on Rs 1.08 lakh, which is Rs 8,640.

At the end of second year, your principal is now Rs 1.08 lakh + 8640 = 116640. Now, 8% interest on that, which is Rs 9331.2.

At the end of 20 years, you would have made Rs 3.66 lakh in interest plus your principal, a total of Rs 4.66 lakh, more than double the amount you had without compounding.

You know what caused the difference, the reinvestment :

Trend lines for Simple Interest vs Compound Interest

The compound interest value earned increases exponentially while simple interest increases in linear fashion. This is because the principal amount invested stays as is, because you decided to withdraw the returns.

This is what compounding is. No rocket science. Very much to be initiated and supported by you only.

You may have also heard that compounding makes money work for you. Now you see how. It sets the growth in motion.

The example above had Rs 1 lakh invested one time. When monthly additions are done to investments, the magic of compounding intensifies!

It also work wonders when done over longer period of time.

Start early, as early as possible

I passed out of college 10 years ago. So did YOU, you were my classmate. You and I were 23 then.

We both started working. Because it was recession, salaries were low. We both started with Rs 18,000 per month. Now, I decided to start saving Rs 2000 per month and asked you to do the same. You said, “well I hardly have any money to use. I will do it once I have good salary”. And so life went on for 10 years.

In this time, I increased my savings by Rs 1000 every year. So 2nd year, I saved 3000 every month. 3rd year, I was saving 4000 every month and so on.

Now today, you have saved nothing while you know what I have? Close to Rs 10.77 lakh

The story does not end here. In fact it is only just starting.

Now you ask me how much am I saving. I am at Rs 12000 per month. So you decide to save Rs 12000 and also increase your savings by Rs 1000.

Then again life goes on as usual.

At 60, you had accumulated Rs 2.35 cr. Great! I had Rs 3.28 Cr.

“But, were you not only Rs 10.77 Lakh ahead of me?” , you ask.

Well yes, that’s what compounding does. Rs 10.77 lakh caused a difference of Rs 92 lakh in our money. The 10 years of small savings I did made that difference. (Because from the age of 33, you and I have been saving exactly same).

In all probability, these roles are reversed. You have saved and I have not. But putting you there just helps in explaining that if you have not yet started, please do. Don’t wait for that dream salary when you will save Rs 1 lakh per month.

Starting early is much more important than starting big. Because compounding shows results in long term. It takes its own sweet time.

Now, just because this is a concept note/dictionary, here’s the formula for compounding.

(Only useful for someone interested. Only applicable to be used directly in case of one time investment. If you have SIPs and want to see how it will compound, it is complicated. Lot of online calculators out there, please use them.)

Amount = Principal(1+rate/n)^(n*time)

n is compounding frequency.

Time is in years.

So you want to see how 1 lakh invested today will grow in 10 years at 8% per annum.

Principal = 100000

Rate = 8%

N = 1 (since compounding is per annum, once a year)

T = 10 years

A = 100000*(1+8%)¹⁰

A = 215892.5

Ta Da!

For people interested, now tell me this.

Would you prefer receiving Rs 3 lakh today or Rs 1 increased by 50% everyday for next 30 days? (Meaning Re 1 on Day 1, Rs 1.50 on Day 2, Rs 2.25 on Day 3 and so on.)

Originally published at She Talk Cents.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s