Albert Einstein says, "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t it pays it.”
It is a fact that many did not realize how powerful compounding is. Hence it is very important to understand the “power of compounding”. The concept of “compound interest” is an important aspect of financial planning. It refers to the capacity of an investment to generate earnings both on the principal amount and also on the accrued interest resulting in exponential growth over a period of time. Let us understand the secrets, benefits and real-life examples.
The snowball effect
Snowball effect explains how small actions can lead to big gains over time. Just like a snowball rolling downhill picks up more snow and becomes a gigantic one when it reaches the bottom of the hill, regular and consistent investment can bring substantial wealth. For example, a Systematic Investment (SIP) of $1,000 monthly in a consistently performing Mutual fund for a term of 20 years can bring a wealth of say $1,036,553 at the end of the term at a CAGR of 12% p.a. The reason behind this magic is that the returns generated are re-invested allowing the investment to grow multi-fold.
Understanding compounding
The key factors that impact the concept is the amount of investment, rate of interest, time and the frequency of compounding viz daily, monthly, quarterly, half yearly or yearly. The more frequent the compounding cycle, the faster the growth of the investment. For example the maturity value of a lumpsum of investment of $100,000 for a period of 20 years at an interest of 10% p.a will be $672,749 if compounded on an annual basis whereas the maturity value will be $732,807 if compounded on a monthly basis. The maturity value will be just $300,000 if invested on simple interest basis. Long term investments unlock the full potential of compounding leading to an exponential growth. A monthly investment of $5,000 for a period of 20 years at an interest rate of 8% p.a. will give you a maturity amount of $3,057,337 if compounded on monthly rests, $29,05,133 on semi-annual basis and $2,745,718 on annual basis as against a total investment of $1,200,000 (all taxes ignored).
Strategies
The power of compounding plays an important role in financial planning. The following strategies will help to achieve a decent wealth creation, if followed meticulously:
Invest early
The earlier the better is the thump rule. The general tendency is to defer the process of starting an investment with no valid reason. This is a mistake often people commit, particularly youngsters. To leverage the magic of compounding one has to start investment at the early ages. Warren Buffet, one of the richest person in the world, started his investment at the age of 11, but most of his fortune was built after the age of 50. Now at the age of 93, his net worth is $135 billion.
The story would have been different, had he started his aggressive investing 10 years before or delayed it by 10 years or quit investing at the age of 60. Let us assume the primary goal of Mr A & B is to build a corpus which they need 20 years from now. Both wanted to invest $10,000 per month. A started the investment today. A will get a whopping sum of $5,988,206 at the end of the term (July 2044) at 8% p.a. compounded quarterly. B delayed the investment and started 5 years later. B will get a maturity amount of $3,494,468 at the end of the term (July 2044) at 8% p.a. compounded quarterly. So the notional loss of B is $2,493,738 (taxes ignored).
Invest regularly
Rainfall may be little in shape and size. But their continuous fall makes a river overflow. Do consistent contributions to your portfolio at regular intervals irrespective of the market conditions. Increasing the investment at regular intervals can make a spectacular difference in the long-term horizon. Often, this vital aspect is not being given due attention by the investors.
Stay invested for long- term
Compounding works wonders over a longer period. Irrespective of your investment in debt or equity, the focus should be on the long-term accumulation of wealth through disciplined and systematic investments. The examples furnished above clearly shows the need to stay invested for a long term for exponential growth of your wealth.
Do not withdraw
To achieve the primary goal of financial planning and to unlock the magic of compounding, stay invested and do not resort to periodical withdrawals to meet contingencies or other expenses. Build a diversified portfolio that includes short-term instruments to meet unforeseen expenses. Allow the core investment to grow. Similarly re-invest the profit realised/dividend received in respect of your investments without using it for consumption purposes.
Be patient
The secret of the power of compounding is time. Therefore it is important to have a long-term approach towards investing. This is more applicable in respect of investments in equity market or equity-oriented mutual funds. The investments in the stock market are subject to volatility and market risks. There may be temporary adverse movements in the market and you may see an erosion of wealth which is only notional. Do not expect overnight miracles.
Conclusion
No doubt, the power of compounding is an important tool of long term wealth creation. But there is a flip side of this when it comes to long term borrowing like housing loans, vehicle loans and also credit cards dues when carried over. The awareness of financial products and services play an important role in managing personal finance. While one has to recognize the extra ordinary power of compounding, remember there is no magic in the true sense of the word, but it is pure mathematics.
R Madhusoodanan
The writer is a former SBI and Financial Planner currently resident in Oman.
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