The Value of Compounding

Mar 22, 2012
It's not just how much money you start with that counts, it's also how much time you allow that money to work for you.
 

Compound interest arises when interest is added to the principal of a sum, so that from that moment on, the accumulated interest that has been added also earns interest.

We see examples of compound interest in our everyday finances, both working for us, such as the interest in our checking accounts and investments, as well as against us, such as the interest accrued on credit card balances, mortgage payments, etc.

When it's working for us, the great part about compound interest is that it can help us to achieve our financial goals, such as becoming a millionaire, retiring comfortably, or being financially independent.

To see how it works, consider the following scenario:

Q: Would you rather have Rs 10,000 per day for 30 days or a paisa that doubled in value every day for 30 days?

A: If you chose the doubling paisa, you'd be a happy camper. At the end of 30 days, you would have over Rs 50 lakh versus the Rs 3 lakh had you chosen Rs 10,000 per day.

Start early!

As you can see from the table above, one of the key concepts about compounding is this: The earlier you start, the better off you'll be. Let's consider the case of two investors, A and B, who are both investing with the goal to become millionaires.

Say Investor A put Rs 2,000 per year into the market between the ages of 24 and 30, that he earned a 12% after-tax return, and that he continued to earn 12% per year until he retired at age 65.

Investor B also put in Rs 2,000 per year, earned the same return, but waited until he was 30 to start and continued to invest Rs 2,000 per year until he retired at age 65.

In the end, both would end up with about Rs 1 million.

However, Investor A had to invest only Rs 12,000 (i.e., Rs 2,000 for six years), while Investor B had to invest Rs 72,000 (Rs 2,000 for 36 years) or six times the amount that Investor A invested, just for starting six years later.

Clearly, investing early can be at least as important as the actual amount invested over a lifetime. Therefore, to truly benefit from the magic of compounding, it's important to start investing early. We can't stress this fact enough!

After all, it's not just how much money you start with that counts, it's also how much time you allow that money to work for you.

Be mindful of the rate

In addition to the amount you invest and an early start, the rate of return you earn from investing is also crucial. The higher the rate, the more money you'll have later. Let's assume that investors X and Y who, at age 24, began saving Rs 2,000 a year for six years.

But unlike Investor A in the previous example, who earned 12%, Investor X earned only 8%, while Investor Y did not make good investment decisions and earned only 4%.

When they all retired at age 65, Investor A would have Rs 10,74,968, Investor X would have Rs 2,53,025, and Investor Y would have only Rs 56,620.

Even though Investor A earned only 8 percentage points more per year on his investments, or Rs 160 per year more on the initial Rs 2,000 investment, he would end up with about 20 times more money than Investor Y.

Clearly, a few percentage points in investment returns or interest rates can mean a huge difference in your future wealth.

TIP: A simple way to know the time it takes for money to double is to use the rule of 72. For example, if you wanted to know how many years it would take for an investment earning 12% to double, simply divide 72 by 12, and the answer would be approximately six years.

The reverse is also true. If you wanted to know what interest rate you would have to earn to double your money in five years, then divide 72 by five, and the answer is about 15%.

Add a Comment
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Nazim Khan
Aug 13 2012 12:18 PM
Mr Paranjape: It's a known fact that equities are a long-term product. Now how long is long? Generally, at least a five-year period (or minumum, a three-year period) should be a must for someone who wants to make money in investing in equities (and i emphasise on investing, not trading around).
Of course, it also depends on one's entry point. An investor who entered at bubble valuations of 2007 (with Sensex trading at 24 times earnings) didn't make money five years after or if a U.S. investor who entered the market at the 2000 peak (after a 20-year rally in equities) may still likely be under water.
But unless one has got their timing horribly wrong, they will always get better long-term returns from equities. Indian investors who seek returns in a one- or two-year period from equities are investing in the wrong instrument (unless they're confident of their trading skills).
For more, I would like to point you to this wonderful piece written by an ex colleague of mine here: http://blogs.economictimes.indiatimes.com/moneyhappyreturns/entry/how-long-is-long-term
Regards,
Nazim
A S Paranjape
Aug 13 2012 09:41 AM
Nazim Khan, awaiting reply to my below posted comment. Compounding appears to be relevant in theory as in practice investors are seeking returns in less than 5 years.
A S Paranjape
Aug 4 2012 01:42 PM
Very long term data of 50 and 100 years is of no use to common investor. Even 10 years data is of use to very few investors or for investors who are planning beyond 10 years. And again compounding theory cannot be applied for equities as gains are not linear or predecided. Returns are -ve many times.
Nazim Khan
Apr 4 2012 12:10 PM
AS Paranjape: But over the long term, equities generally outperform fixed-income investments. 10- and 30-year stats in India and even 50- and 100-year data in the US prove it. So long-term investments in equities would provide higher rates of compounding return over fixed income. Nazim Khan Site Editor Morningstar.in
A S Paranjape
Apr 4 2012 12:01 PM
You can choose the ROI only for fixed income investments but not for Equities In the hindsight you calculate that you have got ....CAGR on the amount invested. This ROI is not in your control at all and you have to be optimistic and wait for the day market goes up,
Pervez Driver
Apr 2 2012 02:43 AM
Great article , first brick or simply put the cornerstone for sucessful long term continous investing.
bimal upadhyaya
Mar 29 2012 03:22 PM
nice artical.please give some suggestions or advise on indian stock market.
CHANDRASEKHAR K
Mar 24 2012 02:15 PM
Great article. Look forward to more such inputs.
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