Albert Einstein is quoted as saying, "The most powerful force in the universe is compound interest." We can say it to be the “Eight Wonder of the WORLD” The concept is clichéd, overused from an investment perspective; it may be ill-timed to reiterate the power of compounding, especially when the market is down in the dumps.
Disciplined investment can go a long way, one need to get bogged down by intermediate glitches such as these. Anil Jha, 25, a computer consultant walked into my office; he had only one goal: he wanted to become a millionaire. No, he wasn't inspired by the movie Slumdog Millionaire. In real life it is not all lucky enough to win a million on a game show. He wanted to put his money to hard work!
What is compounding?
Here we are trying to define the mathematical term; the achievement of academics is to apply them in daily life. The wonder of compounding is to make your money work for you. Compounding is the process of generating earnings on your asset's reinvested earnings. Compounding works on two basic premises: re-investment of earnings and time. The longer time you leave your money to compound, the higher is the wealth you generate.
"Time is the most powerful weapon in an investor’s arsenal. Nothing comes close to it." The mantra is to start Investing early in life and do not get late at all. Also it shows how powerful compound interest and regular investing is. When we invest early in our lives, the amount keeps growing and when it becomes a big chunk, the growth in amount every year is a lot more, compared to initial years.
Compounding Effect – Rice on Chessboard
A courtier presented the Persian king with a beautiful, hand-made chessboard. The king asked what he would like in return for his gift and the courtier surprised the king by asking for one grain of rice on the first square, two grains on the second, four grains on the third etc. The king readily agreed and asked for the rice to be brought. All went well at first, but the requirement for 2n - 1 grain on the nth square demanded over a million grains on the 21st square, more than a million on the 41st and there simply was not enough rice in the whole world for the final squares.
The total number of grains of rice on the first half of the chessboard is 1 + 2 + 4 + 8 + 16 + 32 + 64 + 128 + 256 + 512 + 1024 … + 2,147,483,648, for a total of exactly 232 − 1 = 4,294,967,295 grains of rice, or about 100,000 kg of rice, with the mass of one grain of rice being roughly 25 mg.
The total number of grains of rice on the second half of the chessboard is 232 + 233 + 234 … + 263, for a total of 264 − 232 grains of rice. This is about 460 billion tones, or 6 times the entire weight of the Earth Biomass.
On the 64th square of the chessboard there would be exactly 263 = 9,223,372,036,854,775,808 grains of rice. In total, on the entire chessboard there would be exactly 264 − 1 = 18,446,744,073,709,551,615 grains of rice.
The Chessboard story is a mind boggling illustration of how the power of compounding can do wonders which is dubbed as “The 8th Wonder of the World”. Now that we understand how powerful compounding is, lets us look for ways to make use of this principle to multiply whatever money we have. Now if you are saying you don’t have, relook at your expenses, and get out of debts and start saving now, no matter how small to start with. Put your plan into ACTION.
Compounding Effect – 18 hole Golf Course
Let me give you another example to illustrate the power of compounding. Let's say we played a game of golf and we made a friendly bet of 10-paisa on the first hole, with the bet doubling on each hole. Would you take on this bet? Now, if you were familiar with the game of golf, you would know that there are only 18 holes, so how much can the bet be on the 18th hole?
Well let's see how the bet increases on the first 9 holes:
| Hotel 1 | Hotel 2 | Hotel 3 | Hotel 4 | Hotel 5 | Hotel 6 | Hotel 7 | Hotel 8 | Hotel 9 |
| 10 Paisa | 20 Paisa | 40 Paisa | 80 Paisa | 1.60 IRS | 3.20 IRS | 6.40 IRS | 12.80 IRS | 25.60 IRS |
| At the 9th hole, the bet is IRS 25.60. We are already half way there, so how much could it be on the 18thhole? IRS 100? IRS 300? IRS 500? Let's go on. | ||||||||
| Hotel 10 | Hotel 11 | Hotel 12 | Hotel 13 | Hotel 14 | Hotel 15 | Hotel 16 | Hotel 17 | Hotel 17 |
| 51.20 IRS | 102.40 IRS | 204.80 IRS | 409.60 IRS | 409.60 IRS | 819.20 IRS | 3,276 IRS | IRS | 6,553 IRS |
| Hotel 18 | ||||||||
| 13,107 IRS | ||||||||
As you can see on the 18th hole, the bet becomes a whopping IRS 13,107! When given enough time, the power of compounding can turn very small amounts of money into huge sums.
A more important lesson I want to illustrate is that initially, the money grows very slowly. Even at the halfway mark, it is only IRS 25.60. However, the moment it reaches a critical point, the growth becomes exponential! In fact, between Hole 15 and Hole 18, within just 3 holes, it grows from IRS 1,638 to IRS 13,107, an IRS 11,469 difference!
What does this mean to you? You see when you start your investment program of say IRS 1,000 a month; initially the growth is extremely slow. However, once it hits a certain period of time, the growth explodes exponentially! The trouble with most people is that when they see the slow growth during the first few years, they lose patience and abandon their investment plan.
MANTRA FOR “COMPOUNDING SUCCESS”:
Start early
Benefit from compounding There is no truth to statements like ‘I am too young to start saving’. For example, if you want to be crorepati by 45, you would need to invest only Rs.1.6 lakh per year if you start at the age of 25 (assuming 10% returns p.a.). But if you start at the age of 35 you will need to invest Rs.5.7 lakh per year to achieve your ‘crorepati at 45’ objective. If you start saving and investing early, it will set the stage for significant financial growth later in your life.
Have realistic expectations
Greed is bad Most people invest in stocks and expect them to double in quick time. If you want to double your money, either buy a lottery or go to a casino (but be prepared to lose everything). Stock market is not gambling. The market is ultimately a reflection of economic growth. As such one needs to align one’s expectation of returns in line with the expected GDP growth.
Compare
The performance of your portfolio with relevant benchmark indices and develop realistic expectations. Expecting unreasonable returns will surely cause disappointment, leading to excessive risk-taking.
Invest regularly
Use time not timing Market timing is impossible. You may be lucky once or twice but history has not produced a single investor who has made money regularly by timing the market. Don’t panic when the market is dropping and don’t become greedy when prices are rising. Emotions can be the greatest enemy to your long-term investment plan. History has shown that when most investors are selling, you may have been better off buying.
Stay Invested
Be a marathon runner The markets have seen lots of ups and downs, but history shows that over time the value of a well-diversified portfolio will increase. That’s because prices don't rise every day – they spurt only during a few short intervals of time. Stay invested for longer periods. It will keep you from making common mistakes such as timing the market, picking bad stocks, speculating on stocks that are worthless, investing on borrowed money, trying to make a killing in some fad-of-the-day stock, etc. The reason most people don't get rich with stocks is that they don’t stay in long enough.
Don't churn your investments
It only increases costs Don’t buy stocks. Buy businesses and that too after due research. And since businesses generally don’t change fortunes overnight, there is no need to get in/out frequently as and when some short-term events play out in the market. Too-frequent trading cuts into the investment returns more than anything else. Remember that the only person who makes money in regular churning is your broker.
Asset allocation
Each investment class is important Build a portfolio that is diversified among different types of investments. Because different sectors of the market move at different times in different patterns, asset allocation tends to reduce the risk of huge losses and improves the chances of stable returns. Lack of a well-diversified portfolio, would leave you vulnerable to fluctuations of a particular investment. However, remember not to over-diversify and own too many investment products – more so if the corpus is small – resulting in higher fees relative to the corpus size.
