The Power of Compounding
“The big money is not in the buying and selling but in the waiting “ - Charlie Munger, Berkshire Hathaway
In the investing circuit, compounding is often regarded as the eighth wonder of the world. We will always keep coming back to the advantage of yours over everyone else while discussing this lesson. Compounded Growth is the reason why most people choose to save in the first place. The Compounding effect is perhaps the strongest force out there that will propel you to start saving and growing your wealth at the earliest. The power of compounding can grow your wealth exponentially.
Let us assume Mr.X holds a Fixed Deposit worth ₹10,000 for a tenure of 365 days at an interest rate of 10% p.a.
A year later, he is eligible to receive ₹11,000 ( ₹10,000*110%)
His annual interest income = ₹11,000 -₹10,000 = ₹1,000
But instead of withdrawing his investment, what if he chose to stay invested for a longer period of time.
This time, Mr.X will receive 10% on the new principal amount i.e. ₹11,000
Hence his annual interest income will be ₹1,100 (10% of ₹11,000)
Did you notice the difference?
Just by staying invested for one extra year, Mr.X earned an extra ₹100 of interest. Although, this ₹100 may sound extremely frugal at the moment but it makes a big big difference when you are invested for the long term.
Let us assume a hypothetical scenario- Mr.X and Mr.Y have an initial capital of ₹1,00,000 and are scouting for potential opportunities for investment. Both have the same time horizon i.e. 20 years and decide to invest in Fixed Deposits at an interest rate of 8% p.a. Mr.X decides to reinvest his profits whereas Mr.Y withdraws them at the end of every financial year.
At the end of 20 years,
Just by reinvesting a small portion of the interest, Mr.X was able to save a substantially higher amount at the end. Now, work out the math for the compounding effect if the principal would have been higher, say ₹10 lakh or ₹1 crore.
Let us do it again,
The more the principal amount, the higher is the compound effect.
Let us bring another factor into consideration, our favorite one-time.
If Mr.X had invested the exact same amount for a shorter duration say ten years, you would expect the amount of maturity to be exactly half that of the twenty year maturity i.e.
Amount at the end of ten years = 50% * ₹46,60,957 = ₹23,30,454
Let us check for the validity of this thesis,
The amount at the end of ten years = ₹21.58,925
This corresponds to a difference of ₹1,71,529. Huge indeed!
Note- We have already solved the math for you to simplify things. You can calculate CAGR (Compounded Annual Growth Rate) using various online tools.
An initial capital of ₹10,00,000, invested @8% p.a. over twenty years grows to:
Hence proved, the higher the principal and duration invested, the higher is the compounding effect.
Also, keep in mind that we have assumed meagre returns of 8% p.a for conservative investors. The actual return on stocks is much higher. Let us see how much ₹1,00,000 invested in a few large cap stocks exactly ten years ago have fared,
Now, that's impressive!
We have summarized the key takeaways from this module:
- Start as early as Possible - Don’t delay your first investment, Start Now!
- No amount is too small - It is the little drops of water than make a mighty ocean
- Adopt the mentality of wise men - Income - Savings = Expenditure
- Do not keep your savings in the form of idle cash
- Set the primary target of beating the inflation rate
- Traditional method of savings such as Bank FDs and PPF accounts will not fulfill your objective
- Ideally, you should divide your corpus between Equity & other investments ( Gold, Bank FDs, Bonds) in the following manner:
100-Age = Equity Percentage Allocation
- Wealth accumulation is a slow and steady process.
- Set Reasonable risk-return expectations
- Equity is the best performing asset class
- Stocks are in a long-term uptrend.
- Volatility is a boon and we can make it work to our favour.
- Large cap companies have an established track record and are best suited for investors with low risk-appetite.
- Midcap & Smallcap stocks have delivered better returns than their largecap peers but carry higher risk.
- Patience is a gifted virtue and more so for long-term investors.
- Investors must not panic when the market falls but instead add to their positions if they are confident about the prospects of the company.
- Returns are quadrupled when stocks are bought on market declines
- Investors who do not have time to track the markets can seek professional management of their funds and invest via the Mutual Fund (SIP Route) or ETFs
- The StockEdge App is a must have tool for DIY investors
- You can browse through our other modules at ELM School to enlighten yourself about the financial jungle. Start with this.
- Stay invested for the long-haul and enjoy the magic of compounding.