We’ve all heard about the Seven Wonders of the World.
Is there also an Eighth Wonder of the World?
And if there is, what is it all about?
Albert Einstein was once asked about man’s greatest invention. He believed that Compound Interest was the most powerful force in the Universe.
So, why did Einstein believe that?
Benjamin Franklin described Compound Interest in the simplest manner. He said: “Money makes money. And the money that money makes, makes money.”
Now, isn’t that simple? Let’s break this concept down.
When we invest our money, we get a certain % of interest as returns. When the return that we get is invested again, our base for earning further interest increases. In the following period, we earn interest on a higher base.
Hence, the resulting interest is a higher absolute amount.
When the same is repeated for a longer period of 30-40 years, the base keeps increasing considerably thus earning a higher value of interest, consequently increasing the total value of the investment.
As a result, at the end of 30 years, our initial investment would have grown significantly.
You have not only earned a return on your initial principal, but also on the interest that was generated over the years and reinvested.
This is known as the Power of Compounding.
Let’s look at how Compounding works:
At the end of every year, the base for calculating interest has increased by the value of interest earned in the previous year. In year 2, you will earn interest not only on your investments of Rs. 1.5 lakhs + Rs. 1.5 lakhs but also on the Rs 15,000 that you earned in the previous year as interest.
An investment of Rs.7.5 lakhs over 5 years, has increased to Rs. 10 lakhs due to Rs. 2.5 lakhs of interest earned.
Einstein also said: “He who understands it, earns it; he who doesn’t, pays it.”
What did he mean by this?
Well, what he meant was that in the first case the bank is the one “borrowing” money from you. Hence, you are paid an interest by the bank and you reap the benefits of compounding.
However, if you are the borrower, and you fail to make payments of your loans or credit card, then the amount that is due will keep on increasing geometrically.
This means that you will be charged an interest on your unpaid interests along with the due principal amount. Your debt will grow with each unpaid billing cycle.
Hence, compounding is a wonderful thing only when you’re the one earning it. It is completely your choice to make it your ally or your enemy.
How to take maximum advantage of this powerful force?
There are a few points to note in order to make the most of the power of compounding.
- Start Early – The sooner you start saving and investing, the more time you’ll have to take advantage of compounding. Over time, compounding can add a lot of fuel to the growth of your savings. The magic of compound interest is in the duration an investment is allowed to grow.
- Maintain Discipline – The power of compounding works even better when you increase the quantum of investment every year. It is very important to contribute to increasing the base and maintaining discipline in saving regularly to let this work in your favour.
- Stay Invested and Do Not Exit – The power of compounding works best in the later years when the base has grown significantly. The first few cycles might not seem impressive, but over the years the growth is exponential. Hence, it is very important to stay invested and continuously reinvest your earnings. Do not fall prey to the movements of the market. Continue to hold the investment through the troughs to reap the benefits later.
“The first rule of compounding: Never interrupt it unnecessarily.” Charlie Munger.
The investment of Rs. 7.5 Lakhs over 5 years at 10% rate of return, if left invested for 30 years grows to a whopping 1.09 crores at the end.
Isn’t that a mind boggling figure?
The Rule of 72 (or 114 or 144)
This rule helps to find the number of years it will take for you, at a given rate of interest, to double your money, assuming that the interest is compounded annually.
Suppose you were to evaluate an investment based on your financial goals, where returns are promised at 8% p.a. To find out the period in which your money would double, all you need to do is divide 72 by the rate of interest.
Simply speaking, your money would double in 72/8 i.e. 9 years.
With just a little variation, you can also find out in how many years your money would become 3x or 4x.
When you divide 114 by the rate of interest you will get the number of years your money would take to triple.
And with 144, you will get the number of years your money will take to quadruple.
72/8 = 9 years to 2X
114/8 = 14 years to become 3X
144/8 = 18 years to become 4X
The Rule of 72 can also be used in reverse, to know the rate of interest required to double your money to achieve your goal.
If you want to invest Rs. 2.5 lakhs today to get a maturity value of Rs. 5 lakhs at the end of 5 years, you need to find an investment instrument that gives a return of 72/5 i.e. 14.4% p.a.
Another interesting analysis that can be done is to evaluate the impact of Inflation. The “Rule of 72” can also calculate the amount of time it will take for inflation to reduce the value of money by half.
At a rate of inflation of say 4.5%, it will take 72/4.5 i.e. 16 years for the current value of your money to become half. It means that at the end of 16 years, you will only be able to purchase goods worth 50% value of what you can purchase today.
Hence, it is important to invest in instruments that have inflation-beating capacity. Gold would be a clear winner in this category.
“The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling.” Seth Klarman
Take advantage of it and change the course of your wealth creation.
It’s never too late or too early to start saving.
Get Going Now.