One of History’s most famous scientist Elbert Einstein said that ‘’Compounding interest is the eighth wonder of the world’’. According to him, compounding interest is the most powerful for the universe. “He who understands it earns it; he who doesn’t, pays it,” Albert Einstein reportedly said.
The power of compounding works by increasing your wealth exponentially faster. It puts the interest earned back into the principal and then reinvests the entire amount to accelerate the process of making a profit. In Simple terms it is a process which allows you to earn interest on interest, thus your money works on your behalf for gaining growth. The growth rate of money increases because further investments are generated from both, initial principal amount as well as the previously earned interest amount. The money keeps growing this way and you get wealthier with the time.
The power behind Compounding Interest – Let us understand the power of compounding by the following story:
A long time ago, there was a very brave and honest king, the king was so impressed, with a barber who had done a noble deed for the kingdom, he wanted to reward the barber. When the barber heard this, he replied: My wish is simple. I want only one grain of rice for the first square of the chessboard, two grains for the second square, four grains for the third square, eight for the fourth square, and so on for all 64 squares.
The barber said: Please double the number of grains in the next square compared to the previous square.
The king was surprised to learn that the barber had asked for such a small reward. He happily agreed with the barber’s request. However, after a week, the king’s treasurer reported that the reward would be a much larger number than all the rice that could be produced in many centuries!
Do you know how much rice it would be when we reached the 64th square of the chessboard?
As stated earlier, in the first square of the chessboard there is only one grain. But when you reach the 64th square, there are 18 million trillion grains of rice. This is more than enough to cover the entire surface of the earth.
We all behave like the king in one way or another. It is difficult to understand how the “Power to duplicate or to compound” makes numbers grow:
The Logic behind power of Compounding Interest – There are two factors behind the power of compounding:
- Start investing early in your life. It doesn’t matter how small these investments are, but start investing any small amount you can save. Ideally, the starting point should be the 1st month when you start earning. Therefore, as soon as a person begins to earn money, he must begin to invest.
- Let your investment grow consistently without doing unnecessary withdrawals in between.
The Logic behind power of Compounding Interest –
Compounding is a simple, but very powerful concept. It can be compared to snowball. When you throw a snowball from the top of the hill, It rolls down. In its way, the snowball picks up the snow coming in contact with the ball. By the time, the ball reaches the bottom point of the hill, more snow adds to the ball and snowfall grows bigger in size.
This is exactly what compounding does to your money. You start with a small amount. As time passes, the money grows to a huge amount. You must emphasize towards the fact that compounding can’t make you rich quickly but it will definitely expedite your wealth over a decade or so.
The rule of 72 –
Rule of 72 might help you in understanding compounding. Rule of 72 gives you doubling period. In short it explains how long your investment will take to double. This rule says that to know doubling period you divide compound rate of return into 72 and you get doubling period in number of years. e.g. if your investment generates 12% return then 72/12 = 6 is the number of years require to double your money.
So if you park your money in fixed deposit giving 9% return you will require 72/9 = 8 years to double your money. Similarly if you want your money to be doubled in a period of 5 years(72/5=14.4%) it must be invested in such an instrument which gives 14.40% return every year.
Here is a chart of returns on compound interest vs simple interest. The principal amount is Rs 1 lakhs and annual returns on both simple and compound interest is 15% for a period of 20 years..
So after 20 years amount received from simple interest is Rs. 4 lakhs and from compounding interest it is 14 lakhs.
No matter how small you get started, the important thing is to start investing early in your career/life so that your money can get time to get compounded over period of time. As an investor who starts early and has time on his side, he can look to asset classes as equity to create real returns and create great wealth. The important thing is not how much money you invest, but more importantly how early you start and how long you remain invested.
In this article, we have looked at the power of compounding for our investment. In the next article, we will analyze how to save for investing.