If you have learnt the basic difference between simple and compound interest in school, then the power of compounding is exactly based on that. Let us understand this point with a hypothetical example. Two persons deposit a sum Rs 10,000 with the local money lender. The money lender agrees to pay them 1% as interest each month but gives them two options. Either they can withdraw the interest each month or put it back with the money lender and grow their deposit. While the first investor decides to withdraw the interest each month, the second investor decides to put the interest back with the moneylender. What happens at the end of 25 years?
The first person has withdrawn the interest of Rs 100 each month and spent it. He is still left with the deposit of Rs 10,000 at the end of 25 years. But what about the second person who reinvested the 1% interest each month. At the end of 25 years, the second investor will be sitting on a corpus of Rs 197,885/-. If you are surprised how the second investor grew his wealth nearly 20-fold, it is because of the power of compounding. When you keep reinvesting the money, then not just the principal but event the accumulated interest starts to earn interest.
Power of compounding with respect to equities
Power of compounding looks quite clear from the point of view debt and the interest being put back. But how will the concept of compounding work in case of equities? The concept is the same but the operation is slightly different. Every company has the choice to pay dividend from earnings. Generally, wealth is created by companies that can reinvest most of their earnings in the company at higher ROE. This drives growth and profit margins and enhances the stock price. Another value is to look at power of compounding from the point of view of an equity mutual fund. For example, instead of opting for a dividend plan, you opt for a growth plan and avoid the temptation of withdrawing money from the mutual fund corpus. But even when you opt for growth funds, there are other factors that determine how the power of compounding actually impacts your wealth creation. Let us look at this aspect of fund creation with a comparison of the investment performance of X and Y; both of whom are invested in the same fund.
Is there a problem with these numbers?
Your first reaction to the above table could be that something appears to be wrong! Both X and Y have invested Rs 24 lakh, but X has ended up with vastly higher wealth than Y. The difference lies in time given to your investment for the power of compounding to work. For example, X invests Rs 10,000 per month for 20 years and accumulates Rs 1.52 crore. On the other hand, Y ends up with a little over 1/3rd of X's corpus although he saved twice as much each month. But Y invested for only 10 years and the power of compounding always is a lot more powerful and impactful over longer periods of time than over shorter periods of time. In fact, since Y starts 10 years late, he would have had to invest more than Rs 50,000 per month to create the same level of wealth as X.
Let us see how to make the power of compounding work best for you
What the story of X and Y highlights is that growing wealth in the long run is all about applying the power of compounding. Here are some ground rules to make the power of compounding work in your favour...
# The earlier you start, the longer you earn returns and the longer your returns earn additional returns. Time matters more than size of investment and yield.
# To experience maximum benefit of power of compounding, you need to be invested in equities for longer term. Over longer periods, the risk of equity volatility also reduces substantially.
# The power of compounding forms the basis of investment and financial planning. Between your limited means and your unlimited desires, lies the ability of investments to convert money flows into wealth. That would not be possible without the power of compounding!
(By Sandeep Bhardwaj, Chief Sales Officer, Angel Broking Ltd)