The concept of the power of compounding is based on the mathematical concept of Compound Interest. Observing the compound interest formula will highlight the factors that contribute to compounding over time.
What this formula is referred to as compound interest? The phenomenon of compounding interest says that in the initial periods of investment, one earns interest on the principal. Then in subsequent years, our investment starts to earn interest on interest. The longer the money stays invested, the more interest on interest is earned. This is what is referred to as the compounding of returns.
A simple example. Suppose you’ve invested Rs.1,000 in a fixed deposit for two years that earns 8% per annum interest. At the end of the first year, your principal amount (Rs.1,000) will earn an interest of Rs.80. Hence, the final amount at the end of the year will be Rs.1080 (1000+80). In the second year, the Rs.1080 becomes the principal and now it’ll earn the interest of 8%.
What will be the final amount at the end of the second year? Both, Rs.1000 and Rs.80 will earn the interest. Check this formula:
= 1000*(1+8%) + 80*(1+8%) = 1080+86.4 = Rs.1,166.4
In the first year, interest earned by Rs.80. In the second year, the interest-earning was 86.4. This way, the interest income will infinitesimally grow over time. This is called the compounding of investment returns.
The Key Variables
The compound interest formula has three variables, the invested amount, rate of return, and time. But what really gives the formula the power of compounding is a combination of time and the rate of return.
What we common men can learn about investing from the formula? Two critical lessons:
- Time Factor: The longer we’ll hold our investments, the bigger they will become. Here the longer time horizon is not counted in days or months, but in years and decades. For me, a couple of decades is sufficiently long. When I invest, particularly in stocks, I intend to hold them for the period. The reason I’ve kept the time factor as number one is because it is in our control.
- Rare of Return: Compared to the time factor, earning the expected rate of return is less in our control. Though, investing rationally can drastically improve our chances of higher returns.
This is how wealth is built. It is a secret that rich people do not talk about. They silently keep investing their monies and let it compound for a very long time.
People like Jef Bezos, Elon Musk, Warren Buffett, Bill Gates, etc have invested in their own companies. Their companies gave them the ability to earn high returns. But they still had to manage the “Time” part themselves. So what did they do? They held on to their shares for like forever.
[Suggested Reading: How the idea of business is more financial independence compatible than a job.]
We, ordinary people, do have our companies to invest in. So what we can do? We can invest in shares of good companies listed in the stock market. If one is not comfortable with stocks, mutual funds are the next best alternative.
Everyone who has become sustainably rich is using the power of compounding. It is our key to breaking the boredom of life and becoming financially independent.
Power of Compounding & Time
The above table shows a quantum of Rs.7,50,000 being invested at a 10% rate of return. Twenty different holding times have been shown. In the first case, when the holding time was 1-Year, the invested corpus increased from Rs.8,25,000. Similarly, with a holding time of 16-Years, the corpus rose from Rs.7,50,000 to Rs.34,46,230.
The power of compounding can be considerably enhanced by increasing the holding time. The mathematical explanation of the effect of compounding is simple. So I’ll leave the maths to you. Allow me to explain the effect of time in simpler terms.
Suppose, you’ve invested Rs.7,50,000 at a 10% rate of return. You will need this money after 19-Years from today for your child’s higher education. At the end of the nineteenth year, the size of the investment would be Rs.45,86,000. Now, you could hold on to another 1-Year at least, your corpus size will grow from Rs,45,86,000 to 50,45,000.
Just if one year, your invested money will be grown by 4,59,000. This amount of 4,59,000 is 61.2% of the principal amount you’ve invested.
Inference: For a common man, this is the easiest trick to follow from the investment book. Just holding on to a reasonably good investment will work. Buy a good multi-cap mutual fund, and simply hold on to it for the next 20-year. Let the power of compounding work for you. A multi-cap fund yielding 16% per annum return will multiply your invested corpus by 19.5 times in 20-Years.
Power of Compounding & Rate of Return
A combination of the high rate of return and a long holding time creates even fantastic results. It’s like, the multiplying factor of the compound interest formula gets a double-engine.
To understand the double-engine effect, we’ll use an example where the return will be increased incrementally. We’ll then observe the effect of this increment on the investment corpus.
The above table shows an investment amount of Rs.7,50,000 invested for a period of 20-Years. Here the variable is the rate of return. At a 10% per annum rate of return, the invested amount will grow from Rs.7,50,000 to Rs. 50,45,625.
Now, just by earning a fractional more return of 0.6% (10.6% per annum), the invested amount will grow to Rs. 56,25,535. You can see that even a small increment of 0.6% is bringing about an 11.5% growth.
Similarly, an increase in investment return by 2.4% (12.4% per annum), is bringing about growth of 54% in the overall investment corpus.
So, we retail investors must be on the lookout for opportunities that can yield about 2-3% higher returns than normal. Keep saving and keeping the money aside for such events. When the opportunity, grab it by investing a lump-sum amount.
Inference: How a common man will get such opportunities. Keep tracking the main indices of the market (Sensex, Nifty-50, Next Nifty-50, BSE 100, etc). These indices keep correcting themselves by about 2-3% at least once every year. In those moments of correction, make sure to buy a good index-linked ETF. Once they are bought, make sure to hold on to them for the next 20-Years. Idea is to let your return compound by keeping your money invested.
The Rate of Return & Investment Vehicle
The above table shows the power of compounding in action. What makes this table more useful is it highlights the effect of high returns on the invested amount. The table shows how the invested amount of Rupees one lakh grows over time (25-Years) when invested in stocks, mutual funds, index funds, gold, fixed deposit, and savings account.
In the initial years, the effect of compounding is not as visible. The invested money (Rs.1,00,000) multiplies at a nominal rate. But look at how fast the money starts to grow after a decade.
- Stocks: Between years 10 and 14, the invested money almost doubles itself every passing year. It means it is growing at a rate of 100% per annum. Furthermore, between the years 24 and 25, the invested money (Rs.1.0 lakhs) grew by 800% in one year (from Rs.45 to 53 lakhs).
This is my favorite example to visualize the power of compounding. Every time see this table, it motivates me to invest wisely (for higher returns) and stay invested for a very very long time (like 20-years or more).
Compounding of Money & Goal Management
An above table is a tool made from the concept of the power of compounding. We can use this table to manage our financial goals. The table shows how Rs.1 multiples itself over time at different growth rates. How it can help a layman manage goals?
- Example#1: Suppose a person will need Rs.2 lakhs after 5 years from now. What should be his/her investment plan? The above table tells us to invest Rs.1 lakhs in equity, like a mutual fund, that can earn about 16% per annum return.
- Example#2: Suppose a person will need Rs.3 lakhs. But he will need it after 15-years. As the time horizon is longer, even a smaller rate of return will work. Hence, investing in even a hybrid-based fund will work. The above table tells us to invest Rs.1 lakhs in a hybrid fund, that can earn about 8% per annum return.
- Example#3: Suppose a person wants to build a retirement corpus of Rs.2 crore in the next 18 years. Investing in a stock portfolio that compounds at 18% per annum for the next 18-Years will yield a multiplying factor of 19.67. It means, that if the person invests Rs.1 Lakhs, it grows to become Rs.19.67 lakhs in 18 years. Similarly, if the person investors Rs.10 lakhs today, it will compound to become Rs.1.97 Crore in 18-years.
How much you invest is also important
The power compounding is a force to reckon with. But it will not yield the desired effect if sufficient money is not invested. For example, investing Rs.100 at 18% per annum for the next 30 years will build a corpus of only Rs.14,337.
14,337 = 100 * (1 + 18%)^30
What utility this amount will serve 30-Years from now? It will not be enough, right. So as essential it to earn a higher rate of return and keep the money invested, the quantum of invested money is also critical.
For the whole process of investment to yield the desired result, it will start with saving money. The more is saved, the more will be available for investing. Practice the habit of savings month after month (read about the theory of paying oneself).
The most so saved shall be put to work regularly. How to do it? By investing them in suitable investment vehicles. We common men cannot invest in lump-sum. Hence, for us, the process of gradual investing is well suited. What gradual investing does is increase the quantum of the invested money without feeling the load of it.
Now, for example, consider that over the course of the last five years, you’ve invested a corpus of 5,00,000 in an equity-based mutual fund. The fund will grow at the rate of 16% for the next 30 years. What will be the quantum of the final corpus during this time? It will be Rs. 4.3 Crore.
4,29,24,938 = 5,00,000 * (1 + 16%)^30
Now this is a meaningful investment corpus, right?
This is another example that I always keep in mind, the more you’ll invest now, the bigger will be the yield in time to come. Maybe, I’ll have to cut my expenses today, but tomorrow, I can live a more abundant life.
What we can finally conclude from the theories and examples seen above? Following are the key takeaways:
- Invest Early: It helps us to increase the time factor in the compound interest formula. The longer the money stays invested, the bigger will be the final amount. But what does it mean when we say early, in the 20s, 30s? No, what we mean by early is “today.” No matter what is the age of a person who is not investing, the ideal time to start is today. Longer time means enhanced compounding.
- Systematic Investing: We’ll never have big chunks of money available for investing. It is practically possible for us to spare a few thousand rupees each month. Hence, investing through systematic investment plans offered by mutual funds is a good starting point. The idea is to keep increasing the quantum of invested money to a sizeable number. The effect of the power of compounding on a larger invested corpus will be more fantastic.
- Thoughtful Investing: Investing in an index fund and holding on to it for 20 years can easily yield a 12% per annum return. But thoughtful investing will help you earn a few percentage points more. Check this example, you can see, how even a small enhancement in the rate of return influences the final result.
Just by remembering the compound interest formula, we know what factors to control to see the magnificent effect of the power of compounding. The process of wealth building is not complicated, but it requires discipline. We must agree to invest thoughtfully, and regularly, and must also agree to hold investments for a long-time. If we can do these three things, our chances of becoming financially independent are almost certain.
[Suggested Reading: How much money do I need to retire from a job.]