The Magic of compounding
TLDR: The magic of compounding, examples. how to use it?
If you are visiting this blog, that means you are fairly savvy or you are definitely interested in investing and are looking at ways to manage your investments better. Every financial blog has probably has a post related to compounding.
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
―Albert Einstein
It is worth repeating because it is truly magical and unless you can visualise it, can be difficult to comprehend.
Let us start with a little thought experiment. You have 1 dollar (rupee) on day 1 and you have discovered this wonderful investment scheme where your money doubles every day for a 30 days. How much do you think you will have at the end of the month? Before looking at the answer, just think for a few seconds and estimate a number without using a calculator.
What is the answer that came to your head. 10,000, 100,000 or maybe a 1 million? You are so wrong if one of those were your answers.
1 dollar doubled every day at the end of 30 days = 536,870,912
Fig 1: The magic of compounding
Yes, it is 536 Million. Don’t believe me?. It looks crazy high isn’t it. I am sure you can create the same thing in a spreadsheet or calculator, but unless you see the result it is difficult to believe.
Don’t we all wish there were investment options that help double our money every day. But there isn’t. Maybe a more realistic option for equity investments in India the time to double your money is 5 years.
Yes it is too long compared to this example here but that by itself is not a bad thing. The earlier that you start the better it is for your portfolio.
Let us an example. Person ‘X’ is fresh out of college at 21 starting an IT job that pays 25K a month. He manages to save 10,000 every month and invests that in an index fund. Let us go to my favourite Reliance NIFTY JR as an example. The SIP CAGR (Compounded Annual growth rate) of this index over the last 15 years from November 2003 to October end 2018 is 14.6%.
If he hikes his investment in the fund by 10% every year and stops investing when he reaches the age of 31. But he continues to hold this investment for the next 20 years after that. How much would that portfolio be worth when he turns 51?
Calculation
Principal = 0
Monthly investment = 10,000
Investment period = 10 years or 120 months
Holding period = 30 years or 360 months
Returns = 14.6% compounded quarterly (assuming the same return for the whole 30 years)
Annual increase = 10%
So we start with these numbers, so what is the result?
Total principal = 1.912,490.95 (roughly 20 Lakhs or 2 million rupees)
Maturity value = 65,527,090.8 (Roughly 6.5 crores or 65 million rupees)
That is impressive isn’t it?
No fancy investment products, no active trading, no big ideas, just simply compounding that works. A 20 Lakh ( 2 million) investment has grown to this extent. The key variable here is time, if you are late to the investing game and you think you have missed this magic of compounding then don’t. Start today and slowly increase your contribution as much as possible, you will reap the benefits.
Some tips and tricks
How many years would it take for your money to double, triple or quadruple ?
Double : Rule of 72.
If your investment return is 12%, then using the rule of 72, your money doubles in 72/12 = 6 years
Triple: Rule of 114.
If your investment return is 12%, then using the rule of 114, your money triples in 114/12 = 9.5 years
Quadruple: Rule of 144.
If your investment return is 12%, then using the rule of 144, your money quarduples in 144/12 = 12 years
Happy investing - #MyFatFIRE
